Made for You

Analyse the nature and impact of the main types of Investment Risk on Investment Performance.

Investment Principles and Risk Gap 42-49

David Coard FCSI 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.

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

‘Risk comes from not knowing what you’re doing’

Warren Buffet 3

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

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 5

Risk

Is there a truly risk free investment?

 Cash  National Savings Certificates  Post Office?

 UK Government Stock 6

Long term performance OK but….

FTSE 100 Index over last 25 years

7

How long is long term?

FTSE 100 share Index over 12 years

8

Example of short term volatility

FTSE 100 share Index from 1 st -12 th August 2011

Source: Thomson Reuters Datastream 9

Risk

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?

10

Risk

Systematic Risk and Unsystematic Risk

11

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 12

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 13

Modern Portfolio Theory

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 10

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.

15

Beta

 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

Guess what this is charting over last 30 years

GOLD!

Source: Thomson Reuters Datastream 17

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)

18

Risk

Inflation Risk

19

Inflation Risk

Inflation (RPI) over last 50 years

20

Risk

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

When was UK inflation (RPI) last in double figures?

10.9% in 1990 22

Risk

What have the highest rates of inflation been in the last 100 years?

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

Risk

What businesses are particularly vulnerable in times of high inflation?

 Those with high transport costs  Those with high staff costs (schools, nursing homes)  Others?

24

Risk

Inflation back in the headlines following quantitative easing (more on this later!)

What investors are most vulnerable in times of high inflation?

 Cash depositors  Holders of fixed interest investments 25

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

Risk

Income & Capital Growth – Risk of Shortfall

Growth – Risk of shortfall Capital

27

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

Income & Capital Growth – Risk of shortfall

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

Risk

Sentiment

30

Sentiment

‘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

Risk

Interest Rate Risk

32

Interest Rate Risk

What investments are put at greatest risk by a movement in interest rates?

 Fixed Interest investments  Gold?

 Others?

33

10 year UK government bond index since 1990

34

Risk

Key factors in interest rate moves

 The Economic Cycle  Government Fiscal Policy  Inflation Expectations  Preference for liquid investments 35

Risk

Credit Risk

BB+ BB BB B+ B B CCC CC C D

Standard & Poors

AAA AA+ AA AA A+ A A BBB+ BBB BBB-

Moody’s

Ba1 Ba2 Ba3 B1 B2 B3 Caa Ca C Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3

Fitch

AAA AA+ AA AA A+ A A BBB+ BBB BBB BB+ BB BB B+ B B CCC CCC CCC DDD DD D

Investment grade bonds Non-investment grade / high yielding/ junk bonds

36

Credit Risk

Three types of credit risk?

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

Risk

Currency Risk

38

SA Rand v Sterling - Over last 5 years

39

Australian Dollar v Sterling - Over last 5 years

40

Swiss Franc v Euro - Over last 5 years

41

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

Risk

Liquidity & Access Risk?

When is this likely to occur?

In times of uncertainty.

43

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

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

Risk

Political Risk

46

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

Risk

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

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

Warren Buffet 49

Risk

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

Diversification – Relative Risk

Key to reducing risk Return Risk 51

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 Return Risk 52

Diversification – Relative Risk

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 Return Risk 53

Diversification – Relative Risk

‘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

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

Top 5 FTSE companies by market cap

     HSBC Holdings Vodafone Group BP Royal Dutch Shell GlaxoSmith Kline £95bn £86bn £84bn £79bn £69bn

Bottom 5 FTSE companies by market cap

     Ashmore Group Hargreaves Lansdown Lonmin Inmarsat Investec £2.3bn

£2.2bn £2.1bn £2.0bn £1.9bn

56

Risk

Gearing

What constitutes gearing?

57

Risk

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.

2.

3.

Investor has £2500 to invest Sure investment is going to rise so borrows £2500 and invests £5000 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

Risk

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

Diversification

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

Gearing

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

Risk

‘The investor of today does not profit from yesterday’s growth’

Warren Buffet

62

Question time

63

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.

64