What’s The Risk?
Sarah Wakefield, Business Development Manager at Blackfinch Investments discusses managing investment risks.
Risk is defined by the Oxford English dictionary as a noun, referring to ‘a situation involving exposure to danger’ and ‘the possibility of a financial loss’, or as a verb meaning to ‘expose (someone or something valued) to danger harm or loss.’ In fact, the origin of the word ‘risk’ is from the mid-17th century. It derives from the French ‘risqué’ (noun), or ‘risquer’ (verb), and from the Italian ‘risco’ (noun) meaning ‘danger’ and ‘rischiare’ (verb), meaning ‘run into danger’.
We assess risk every day: for example, simple risks, such as the risk of encountering traffic on our daily commute, to the more extreme or remote risk of a force nine-gale demolishing our house. Everyday risks we usually bear little time considering. But we may take our time to consider other risks, possibly obtaining further detailed information before making a decision as to whether or not to accept the risk, or perhaps choose an alternative.
For example, if we discover there was an accident that has caused delays on a longer journey, we might think about taking an alternative route, or allowing extra time to continue with our original route. Armed with information, we can make a more informed decision as to whether the risk is acceptable or not.
Some risks can of course be insured against, as in the case of taking out house and contents insurance, where risk is managed through the decision to build in contingencies for any loss. The decision may be made with consideration of information, such as whether you live in a high-crime area or an area prone to subsistence, which may affect your choice around insurance.
More cautious individuals may choose to insure against all possibilities, whereas others may choose to accept the full risk themselves, and to not insure at all. The provision of information can make decisions, in relation to risk, either acceptable, manageable or somewhat quantifiable.
Managing Investment Risk
The same can be considered in relation to investing. While investment risk can be reduced with diversification, to lower the systematic risk existing across companies and markets, it may not be possible to assess the risk with full knowledge.
Take a portfolio of unit trusts and Open-ended Investment Companies (OEICs). It is possible to have full knowledge of each portfolio company within each unit trust and OEIC; to know the issues and risks to each business. It is also viable to choose a selection of a few unlisted smaller companies with full knowledge of the market in which they operate; the infrastructure of each company; the assets and liabilities; the company ethos; and the company’s track record, down to the parameters of risk that company is prepared to take. With full knowledge of all of this, investors could decide whether investing is an acceptable risk or not.
And unsystematic risk, the risk affecting one company, can be reduced with diversification. Even with smaller companies, looking at a portfolio across different asset classes could reduce an investor’s unsystematic risk. Systemic risk, that affects the whole economy and all companies, is less easy to reduce. We all experienced the 2008 market falls where the FTSE AIM all share fell by nearly 70% from 1234.60 on 13th July 2007 to 376.92 on 6th March 2009. Yet we also know that these were events taking place in exceptional circumstances.
Inheritance Tax: Mitigating A Major Risk
There are of course many risks to consider when looking at an investment, other than the investment risk itself. It was reported to have been said by Benjamin Franklin “Nothing in life is certain except death and taxes.” Certainly, the greatest risk to an individual’s investments in general is the tax impact. And with the tax rate on death being one of the highest, surely that puts this risk at the top of the list.
Consider a client with an ISA worth £100,000, achieving an average annual return of 5%. The compound return over 10 years would be £162,889. However, the impact of Inheritance Tax (IHT), if the investor were to die on the tenth anniversary, would wipe out all the growth and some of the capital, leaving just £97,773 (assuming that the Nil Rate Band and residential Nil Rate Band are used on the property). This would result in an amount less than the original investment 10 years prior.
However, should the investor accept a little more investment risk, say into AIM-listed companies, then Business Relief (BR) could be obtained, in order to in-turn deliver IHT relief, and the net return after all tax would be a 62.8% gain rather than a 2.3% loss. Of course, there is the liquidity risk posed by AIM shares, which may be less liquid than a portfolio of OEICs and Unit Trusts. However, as a traded stock, this may not present a significant issue to investors.
For investors who are seeking to both mitigate IHT and take advantage of AIM Investment, Blackfinch Investments offers a diverse AIM portfolio of 20 – 40 AIM-listed companies. These have been carefully selected with the objective of capital growth and BR for clients. Blackfinch provides AIM portfolios for investors that offer an excellent level of diversification, with little overlap with other portfolios in the market, helping to further reduce risk.
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CAPITAL AT RISK.