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

1. 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.

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

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

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

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

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

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

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

11. Systematic Risk and Unsystematic Risk Risk

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. 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 Unsystematic Risk

14. 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

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 • 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?

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

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 Risk

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

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

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

23. 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.

24. 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?

25. 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

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.

27. Risk 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.

29. 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.

30. Risk Sentiment

31. 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.

32. Risk Interest Rate Risk

33. Interest Rate Risk What investments are put at greatest risk by a movement in interest rates? • Fixed Interest investments • Gold? • Others?

34. 10 year UK government bond index since 1990

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

36. Risk Credit Risk 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

38. Risk Currency Risk

39. SA Rand v Sterling - Over last 5 years

40. Australian Dollar v Sterling - Over last 5 years

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).

43. Risk Liquidity & Access Risk? When is this likely to occur? 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.

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).

46. Risk Political 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

48. 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, KwekuAdoboli at UBS • Staff errors – fat finger syndrome • Regulatory (FSA fine?)

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

50. 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.