Finding the right balance of portfolio risk for you
The level of risk and potential reward you take with your portfolio is up to you. Higher risk investing has its place and can form part of a balanced portfolio. However, it can take many forms and there’s lots to think about.
IN A FEW WORDS
Asset allocation strategiesRisk portfolio managementPortfolio riskHigh risk investing
4 min reading
Risk is part of investing and higher risk investments can have a role to play in portfolios. Managed well, they can be a source of higher growth at a time when broader stock market returns may be unexciting. However, taking the right risks, at the right time and in the right way is important.
There’s a lot to consider with higher risk investing
Higher risk investing comes in many guises, from smaller companies, to emerging markets, to cryptocurrencies. They can be an exciting way to access new opportunities, but there is seldom a shortage of people trying to sell Mongolian property or Venezuelan bee farming as the next hot investment area. Some of these may make you millions, but too many have simply destroyed investors’ wealth.
A recent paper by UK financial services regulator the Financial Conduct Authority (FCA) highlighted the key characteristics of a higher risk investment, designed to encourage investors to make better choices about where to take risk. Perhaps obviously, it showed that these investments target a high rate of return but come with a higher chance of losing money. In the worst cases, investors have even ended up owing money. The FCA points out that higher risk investments may also be less liquid
than mainstream ones. That means it can be harder to get your money out if you need to. The market for the assets may be smaller, leaving them more vulnerable to quick changes in sentiment. While the share price of a FTSE 100 company is unlikely to be influenced by the mood of a few investors, that’s not true for a smaller company with a handful of shareholders. Higher risk investments are also likely to be more volatile. This may be good if share prices are heading upwards but can be stressful if your retirement lifestyle depends on it.
The final consideration with higher risk investments is that they may not offer you the same protections as conventional investments. Small companies can be high risk, but their shares may be listed on an exchange, they have audited accounts and investors have certain rights. Unregulated investments do not have those protections. Some may do well, but if something goes wrong, you can’t claim redress from the Financial Services Compensation Scheme (FSCS). There is also some uncomfortable history with unregulated investment schemes too often ending up on the desks at the Serious Fraud Office.
It's worth sticking to certain rules when thinking about risk and portfolio management
Perhaps the most important is finding the right level of risk and reward for you. That might mean an asset allocation strategy where higher risk assets are used for a small part of your portfolio and for experienced investors. You need to be able to afford to lose it, rather than relying on it for your next home, retirement or, worse, your heating bills.
Equally, you need to be sure those risks are worth it. If you can make 10x your money, it could be worth the potential losses. However, there have been a spate of recent unregulated investments that have offered a high, but not ambitious income. These have been linked to high-risk property schemes and have offered the worst of all possible worlds – relatively low returns for lots of risks.
There are differences in the type of risks you can take. For example, emerging market companies are generally high-risk investments, but they are real companies that generate cash, with real assets. Even if it goes badly, there is likely to be some residual value. This is different to, for example, a cryptocurrency.Cryptocurrencies have no inherent value and trade relative to other currencies. As such, they are likely to be more volatile and could, theoretically, go to zero if investors lose faith in them. In May, Bitcoin fell to its lowest level in 2022, more than 50% down from its all-time price high.
Consider all the options before taking on significant portfolio risk
Even if you’ve got a real hunch that an asset is undervalued and has a lot of growth ahead of it, consider the other possibilities. Investors are prone to over-confidence in their decision-making. You may be very confident that inflation is going higher, but it is worth considering the alternative – that higher interest rates or slowing economic growth could push inflation lower, or that commodity price rises could reverse. If you’re about to double-down on inflation-linked bonds, you need to consider both sides.
Perhaps the most important rule for higher risk investing is not to depend on it working out. Higher risk does not necessarily equate to higher return. The market is generally good at pricing the risk of individual assets and if an asset is cheap it may be cheap for a reason. It’s always worth considering whether there’s something you might have missed that other market participants are seeing. The rule is, if looks too good to be true, it probably is.
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