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In 1750 James Swaine bought a whip- making business in Piccadilly, and a Royal Appointment to King George III quickly followed. Over the next century the.

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Presentation on theme: "In 1750 James Swaine bought a whip- making business in Piccadilly, and a Royal Appointment to King George III quickly followed. Over the next century the."— Presentation transcript:

1 In 1750 James Swaine bought a whip- making business in Piccadilly, and a Royal Appointment to King George III quickly followed. Over the next century the reputation and product range expanded and Swaine found himself providing bags and umbrellas to the aristocracy of the day. Today the company still uses time-honoured crafting processes for producing fine attaché cases and leather bags. At Charles Stanley we admire this considered way of doing business. Made for You David Coard FCSI Analyse the nature and impact of the main types of Investment Risk on Investment Performance. Investment Principles and Risk Gap 42-49

2 Format 14:00 – 14:10 Introduction 14:10 – 15:00 Main Session – Presented by David Coard 15:00 – 15:15 Break 15:15 – 15:40 Main session to continue 15:40 – 16:00 Q&A Close 2

3 3 ‘Risk comes from not knowing what you’re doing’ Warren Buffet

4 Headline Topics  Liquidity & Access  Income & Capital Growth including shortfall  Short term volatility  Long Term performance  Gearing  Currency  Interest Rates  Systematic & Non-Systematic Risk, including fraud and counterparty, institutional, market timing 4

5 5 What are the main categories of risk we should be concerned about when making any financial investment?  Systematic & Unsystematic risk  Inflation risk  Sentiment risk  Interest Rate risk  Credit risk  Currency risk  Liquidity risk  Event risk  Political risk  Operational risk  Relative risk  Gearing risk  Non-diversification risk

6 6 Is there a truly risk free investment? Risk  Cash  National Savings Certificates  Post Office?  UK Government Stock

7 7 Long term performance OK but…. FTSE 100 Index over last 25 years

8 8 How long is long term? FTSE 100 share Index over 12 years

9 9 Example of short term volatility FTSE 100 share Index from 1 st -12 th August 2011 Source: Thomson Reuters Datastream

10 10 Who should and should not be investing in these markets? What do we mean by risk and what does a client mean by risk? Do they correlate? Risk

11 11 Systematic Risk and Unsystematic Risk Risk

12 12 Systematic Risk Systematic Risk – also known as Market Risks are those risks which affect all companies within a market in one way or another. For example:  Inflation  Recession  Interest Rates  Political Instability  Exchange Rates  War  Confidence

13 13 Unsystematic Risk Unsystematic Risk – also known as Specific Risk are risks which are unique to the company.  Strength of Management ( Marks & Spencer)  Range of Products (Unilever)  Geographic Location (McDonald’s)  Financial Position (B.P.)  Innovational Factor (Apple) Total Risk = Unsystematic Risk + Systematic Risk

14 Modern Portfolio Theory 10 Modern Portfolio theory developed by Harry Markowitz in 1952 indicates that much of the unsystematic risk can be factored out by spreading funds over more investments. How many is deemed to be the minimum? 15-20 Modern Portfolio theory states that 95% of the unsystematic risk can be eliminated with 20 securities

15 15 Beta One of key concepts of investment management and portfolio management is diversification. You can diversify some of the portfolio risk away by investing in investments with different levels of risk measured by a company’s Beta. Beta is the measure of the average historic volatility of a security’s return to the broader market risk and is stated as a proportion of the market risk. Beta for the whole market is deemed to be 1. A stock with a Beta of 1 is likely to move with the market. One with a Beta of 2 will move by twice the market – in both directions.

16  Beta < 1 – Stock described as defensive ( probably income producer)  Beta > 1 – Stock aggressive & cyclical ( probably growth stock)  Beta can also be negative i.e. if market rises, investment likely to fall and vice-versa. Example? 16 Beta

17 17 Guess what this is charting over last 30 years Source: Thomson Reuters Datastream GOLD!

18 18 Alpha Alpha is the risk adjusted measure of the active return on an investment. It is basically a measure of a fund manager’s stock-picking skill, with Alpha being used to measure individual securities, portfolios or funds. A positive Alpha is good news and the higher the better. Alpha= Annual Return - Expected Return Expected Return = Average Annual Risk Free Return + Beta (Annual Market Return-Risk Free Return)

19 Inflation Risk 19 Risk

20 20 Inflation Risk Inflation (RPI) over last 50 years

21 Inflation is a real risk for every company. Why?  Difficulty controlling costs  Budgeting  Goods/services can become uncompetitive  Wage demands escalate as rise in cost of living is highlighted 21 Risk

22 When was UK inflation (RPI) last in double figures? 10.9% in 1990 22

23 Risk 27% in 1975 35% after the first World War Changes in supply & demand can cause sudden rises or falls in prices – Middle East conflict in 1970s precipitated rapid increase in the oil price and thus inflation. 23 What have the highest rates of inflation been in the last 100 years?

24 Risk  Those with high transport costs  Those with high staff costs (schools, nursing homes)  Others? 24 What businesses are particularly vulnerable in times of high inflation?

25 Risk What investors are most vulnerable in times of high inflation?  Cash depositors  Holders of fixed interest investments 25 Inflation back in the headlines following quantitative easing (more on this later!)

26 Risk Historically, which investments have benefited most from inflation?  Shares  Property  Index-linked investments (government stock) However, liquidity requirements may knock the ‘real’ assets theory off course as there needs to be a buyer for a seller to realise his/her profit. 26

27 Risk 27 Income & Capital Growth – Risk of Shortfall Capital Growth – Risk of shortfall

28 Income & Capital Growth – Risk of shortfall Capital There is always a risk that an investor’s capital falls in value rather than grows, thus creating a shortfall – in real terms or in investor’s expectations –Know Your Client especially important in these circumstances. 28

29 Income Income may be cut through a company defaulting on its fixed interest payments or cutting its dividend through a drop in profitability. It may also not raise its dividend by sufficient each year to combat inflation. The more certainty of income is required, the lower the level of income likely to be available or the more in-depth research will be required. 29 Income & Capital Growth – Risk of shortfall

30 Risk 30 Sentiment

31 ‘Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it’ Warren Buffet Not a factor to be ignored but impossible to quantify Investors who believed gold, commodities, property, technology shares, antiques, fine art or even tulip bulbs could only go in one direction have been responsible for many crashes over the centuries. 31

32 Risk 32 Interest Rate Risk

33 What investments are put at greatest risk by a movement in interest rates?  Fixed Interest investments  Gold?  Others? 33

34 10 year UK government bond index since 1990 34

35 Risk Key factors in interest rate moves  The Economic Cycle  Government Fiscal Policy  Inflation Expectations  Preference for liquid investments 35

36 36 Credit Risk Risk Standard & Poors Moody’sFitch AAAAaaAAA AA+Aa1AA+ AAAa2AA AA-Aa3AA- A+A1A+ AA2A A-A3A- BBB+Baa1BBB+ BBBBaa2BBB BBB-Baa3BBB- BB+Ba1BB+ BBBa2BB BB-Ba3BB- B+B1B+ BB2B B-B3B- CCCCaaCCC CCCaCCC CC DDDD DD D Investment grade bonds Non-investment grade / high yielding/ junk bonds

37 Credit Risk Three types of credit risk?  Risk of default  Downgrade risk( US recently by one agency)  Credit spread risk 37

38 38 Currency Risk Risk

39 39 SA Rand v Sterling - Over last 5 years

40 40 Australian Dollar v Sterling - Over last 5 years

41 41 Swiss Franc v Euro - Over last 5 years

42 Risk Currency Risk? When investments made in overseas quoted investments by a UK based investor, there is the risk that the currency will move adversely. Risk also applies to all UK quoted companies with large overseas interests such as GlaxoSmithKline (approximately 90% of turnover outside UK) but not to United Utilities (100% turnover in UK). 42

43 43 Risk When is this likely to occur? Liquidity & Access Risk? In times of uncertainty.

44 Liquidity & Access Risk Particularly relates to smaller companies or unit trusts with assets that are not easy to trade. Market makers protect themselves by reducing the number of shares they will trade to the minimum stipulated by the Stock Exchange in that particular company. Might be 1000 shares at 25p each! Asset classes such as commercial property companies and private equity (for example 3i) can also be vulnerable. On a wider basis, residential property can go from being reasonably liquid to illiquid in a very short space of time. Thus access to liquidity can prove difficult. 44

45 Risk Event Risk Examples?  9/11  Earthquake in Japan  Industrial Accident (B.P.) In B.P.’s case, it was unable to pay its full dividend due to an unexpected event but it could happen as a result of a natural disaster, a corporate change or a regulatory one ( i.e. Hargreaves Lansdown having to adjust its business model as a result of FSA ruling). 45

46 Political Risk 46 Risk

47 Political Risk  Relatively low in the UK these days (but Banking Sector?)  Danger if investing in, say, Egypt (Centamin Egypt)  Change of government creating new fiscal and monetary policies  Quantitative Easing  Change in taxation system  Nationalisation or confiscation of assets (Russia)  Corruption 47

48 Operational Risk (including fraud & counterparty risk) Until now, focused on market or portfolio risk – these are risks that lead to a fall in value resulting in an investor not meeting his/her risk and return objectives. Operational risk looks at risks that arise from the investment process. These include:  Counterparty/Settlement Risk - the counterparty (often institutional), to a transaction may fail to settle – Lehmans. Early structured products particularly vulnerable.  Fraud – internal or external – misappropriation of funds – Keydata - Madoff  Misrepresentation – misleading reports & valuations (tend to come to light in a recession)  System Failure  Trading within institutions – trading errors and unauthorised trading - Nick Leeson at Barings, Kweku Adoboli at UBS  Staff errors – fat finger syndrome  Regulatory (FSA fine?) 48 Risk

49 ‘Only when the tide goes out do you discover who’s been swimming naked’ Warren Buffet 49 Risk

50 Market Timing Timing and timescales are very important but very hard to predict short term movements. Luck is a factor whether you like to admit it or not. Essential to ensure the client understands that, if a long term investor rather than a short term trader, they need to be able to ‘ride out’ any volatility if investing in these markets. Earlier chart showing FTSE movement in first half of August this year is a perfect example of volatility – possible to make or lose 10% in a day during that period. 50 Risk

51 Diversification – Relative Risk Key to reducing risk 51 Return Risk

52 Diversification – Relative Risk What would you expect to be the types of investments at the bottom of the line?  Cash  Bank/Building Societies  National Savings  UK Government Stock  Life Assurance Policies  FTSE 100 Loan stocks  Some collective investments  Structured products  ETFs 52 Return Risk

53 And the investments at the top of the line?  Listed shares  Unlisted shares including AIM  Property  Loan stocks ( ex FTSE 100)  Gold  Other commodities  VCT/EIS  Some collective investments  Structured products  ETFs 53 Diversification – Relative Risk Return Risk

54 ‘Take calculated risks. That is quite different from being rash’ General George S. Patton (American General in World War 1 & 11) 54 Diversification – Relative Risk

55 Diversification can come in various forms  Different Asset classes can be held in portfolio – different betas to smooth out returns  Equity investment spread over world markets. Individual stock markets do not always move in the same direction although correlation has increased in recent years.  Use collective investments rather than individual companies although points 1 & 2 above still relevant.  Spread equity investment across the UK market to avoid reliance on any one sector (i.e, Banks). Do you give the same weighting to Royal Dutch Shell as to Hargreaves Lansdown? 55 Diversification – Relative Risk

56 Top 5 FTSE companies by market cap  HSBC Holdings£95bn  Vodafone Group£86bn  BP£84bn  Royal Dutch Shell£79bn  GlaxoSmith Kline£69bn Bottom 5 FTSE companies by market cap  Ashmore Group£2.3bn  Hargreaves Lansdown £2.2bn  Lonmin £2.1bn  Inmarsat £2.0bn  Investec £1.9bn 56 Diversification – Relative Risk

57 Gearing What constitutes gearing? 57 Risk

58 Gearing Type of risk which involves either borrowing funds to increase the amount available for investment or buying an investment such as an investment trust warrant which will react by a greater percentage than the underlying investment. Options, CFDs and other derivatives have the same geared risk elements. 1.Investor has £2500 to invest 2.Sure investment is going to rise so borrows £2500 and invests £5000 3.Shares rise 50% so sell for £7500 and repays loan 4.Percentage profit 100% less loan costs. However, if shares fall 50% investment wiped out plus costs of loan. 58

59 Key points on risk  Systematic Risk is market risk whereas unsystematic risk refers to specific risk, or investment specific risk.  Inflation is a major risk for investors particularly those invested in cash deposits or fixed interest securities which are not index- linked. Real assets such as property and equities can provide some inflation protection.  Interest Rate risk is measured by duration, fixed interest securities will lose value when rates rise and vice versa. Fixed interest investments are also subject to credit risk.  Investors buying outside their base currency are taking on currency risk.  Other main risks are political, event, liquidity and operational risk. 59 Risk

60 Key points on diversification  Diversification refers to combining risky investments in a way that reduces the overall risk of a portfolio.  Diversification can be carried out at the asset class or geographical level or by holding a diversified portfolio of securities within a single market. 60 Diversification

61 Key points on gearing  Gearing or leverage will increase risk as it magnifies the losses or gains made by an investment when the price of the underlying asset moves. 61 Gearing

62 Risk ‘The investor of today does not profit from yesterday’s growth’ Warren Buffet 62

63 Question time 63

64 64 Important information The information given in this presentation is based upon sources we believe to be reliable, but its accuracy cannot be guaranteed. The information does not constitute advice or a personal recommendation and you are recommended to seek advice concerning suitability from your investment advisor. Charles Stanley & Co. Limited and connected companies, their directors, members, employees and members of their families may have positions in the securities mentioned. Tax reliefs are those currently applying and the levels and bases of taxation can change. Investors should be aware that past performance is not necessarily a guide to the future and that the price of shares, and the income derived from them, may fall as well as rise and the amount realised may be less than their original sum. Charles Stanley & Co. Limited is authorised and regulated by the Financial Services Authority. Registered office 25 Luke St London EC2A 4AR. Registered in England number 1903304.

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