Managing investment risk

2020 was a challenging year in so many ways, including for savers and investors. Here, with the help of Aviva’s Head of Savings & Retirement, Alistair McQueen, we take a look at three approaches that could help you prepare for turbulent times.

During 2020, the FTSE 100, the UK’s leading investment index, went on a rollercoaster ride. Early in the pandemic, the four weeks from 24 February to 23 March saw a drop in value of around 30%. There was some recovery over the following months, but the index still closed the year below where it began 1.

This experience is a timely reminder of the importance of managing investment risk. In roulette, few would recommend placing all your chips on one number. You could win big, but you’re more likely to lose big. The same principle applies to your investments. 

So, let’s look at three common approaches that could help your overall investments cope with the ups and downs of the markets. Remember, with all investments, those ups and downs do still mean that you could get back less than you invest.

Diversification

Diversification simply means not placing all your investment eggs in one basket. There are different ways you could do this. 

You could diversify within one investment type (or ‘asset class’). Say you’re investing in shares, you could invest some of your money in shares that tend to do well in a rising market, for example construction companies. And you could invest the rest of your money in shares in defensive stocks — the ones that tend to do well in a falling market, such as utilities or food retailers. A drop in one sector should hopefully be balanced by a rise in the other.

Another way to diversify is to invest in different sorts of assets. So, instead of investing totally in shares, for example, with some of your money you could select options that invest in bonds, or commercial property, or cash, or a combination of these. If one type of investment doesn’t do well, the overall impact is limited if the other investments perform better.

If you’re thinking of diversifying your investments, Alistair explains you can take a DIY approach or leave it to an investment manager to do the work for you.

“You could choose a range of investments yourself or you could leave it up to an investment manager to do it for you by selecting funds that invest across a number of different asset classes. They go by a number of names, such as ‘balanced managed’, ‘diversified growth’ or ‘multi-asset’ funds. 

“These diversified funds also have a range of charges, depending on whether the underlying single-asset funds that make up the overall fund are passive — that is, they track headline indices such as the FTSE 100 — or active funds which are actively managed by fund managers to seek the strongest return. There can be a wide range of charges for these funds.” 

Hedging

Another way that a fund manager can mitigate investment risk is by ‘hedging’. This simply means that the manager takes out insurance against the value of their investments falling or against the possibility of missing out on a rise in the value of an investment. Investment managers might also hedge against things like currency exchange rates or a change in interest rates affecting the value of their investments.

Alistair says: “There are a few ways hedging can be done, but the most common is to use derivatives. These are financial insurances that allow an investment manager to buy or sell assets such as equities and bonds at a known price at some point in the future. 

“For example, if the manager invests in the FTSE 100 company shares but thought there was a risk that the value of those shares might fall, they might buy an ‘option’ that allows them to sell those shares. If the FTSE 100 Index today was, say 6,200, but the investment manager feared that it might fall sharply, they could buy, for example, an option to sell their shares at a value of say 6,000 in a year’s time. If after a year, if the FTSE 100 stood at 5,000 — a fall of over 20% over that year — the manager could use their option to sell at 6,000 — a fall of less than 5% — which would limit the loss. 

“It’s worth noting, though, that derivatives contracts cost money and that the extra cost acts as a drag on investment performance. It also means that the price of such funds is usually a bit higher than average.”

Funds that use hedging strategies are known by various names such as ‘absolute return’, ‘multi-strategy’ or ‘target return’ funds. Many of them have an objective to deliver a certain return, such as Bank of England base rate plus 5% over a rolling fixed period of say three years. However, there is no guarantee that these funds will achieve the return set out in their objectives and the capital value of your investments might fall.

Smoothing

‘Smoothing’ involves holding back some of the returns earned during periods of good performance and using them to reduce losses during periods of poor performance.

“This is the basic principle under which with-profits funds are managed,” explains Alistair. “While older with-profits funds include guarantees that your fund won’t fall in value, or even that it’ll increase by a set percentage each year, more modern versions don’t offer such guarantees.” 

A newer type of fund, usually called ’smooth managed’, uses a set formula to smooth returns. This is similar to the more modern versions of with-profits. 

How to get help

Unless you’re an experienced investor, the best idea is to leave investment decisions to someone else. If you have a financial adviser, they’ll help you select investments that meet your financial objectives within your personal tolerance for risk. They should also be well placed to help you manage investment risk over time. Pension providers also often offer ‘ready-made’ investment portfolios which are pre-designed to support a specific investment objective and risk appetite.

A final word from Alistair: “Hopefully, few years will be as turbulent as 2020 was. But, regardless, the importance of managing investment risk will remain true. Managing risk today could reap reward tomorrow.”