AFA 1 Investment 2024 Topic 7 - Risk PDF
Document Details

Uploaded by PrettyHeisenberg2096
null
2024
AFA
Tags
Summary
This AFA 1 Investment 2024 past paper covers the topic of risk in investments, including liquidity, income and capital growth, short-term volatility, long-term investment performance, currency, inflation, and systematic/non-systematic risk.
Full Transcript
Topic 7 Risk Learning objectives After studying this topic, you will be able to demonstrate an understanding of the nature and impact of the main risks that could affect investment performance, including: liquidity and access; income and capital growth; short‑term volatil...
Topic 7 Risk Learning objectives After studying this topic, you will be able to demonstrate an understanding of the nature and impact of the main risks that could affect investment performance, including: liquidity and access; income and capital growth; short‑term volatility; long‑term investment performance; gearing; currency; inflation and interest‑rate risk; systematic and non‑systematic risk. 7.1 Risk We looked at the general concept of risk in the Financial Services Regulation and Ethics module; this topic will consider risk from an investment perspective. First, a brief refresher. Risk is associated with the possibility that something harmful or damaging could occur if things go wrong, resulting in some form of damage or loss. Risk is associated with probability; the risks are higher when the situation itself makes it more likely that an adverse event will occur. Risk can be defined as the possible variation in an outcome from what is expected to happen. This definition of risk contains three important elements: — Risk is about variability because future events cannot be predicted with certainty. — Risk relates to our expectations of what will happen. — Risk arises because what actually happens could differ from what is intended or expected to happen. It is important to understand from the outset that risk can never be eliminated. All aspects of life are risky and risk is never zero. Risk can, however, be reduced, ©LIBF Limited 2024. All rights reserved. 245 7: Risk minimised, managed or transferred. We will look later at how this principle applies to investments. It is generally accepted that real investment gains are not made without taking a degree of risk. This topic will look at the concept of risk versus reward and the types of risk that exist. The basic concept is that a ‘low‑risk’ investment is likely to fluctuate less widely than a higher‑risk investment. A ‘high‑risk’ investment has the potential for making larger gains but also has the potential for suffering larger losses. This is commonly known as the concept of risk versus reward. In general, the higher the risk, the higher the potential reward or loss, but, when looking at the risk factor, it is important to understand exactly what we mean by risk. Investment risk is commonly understood in terms of the loss of the amount invested or of making little return on the investment. We sometimes forget, though, that there is the risk of lost opportunities – what might have been earned had the investment been made elsewhere. Time is an important risk factor. Consider an investor who has £1,000 to invest for one year. If that £1,000 is invested in a building society account, the capital is secure and the investor will receive interest at the rate applicable during that year. If they were to invest the £1,000 in shares, the investment might fall in value and the investor could not be sure how much dividend income they would receive, if any. If, however, the investor intended to invest for ten years rather than one, the risks alter. Although stock market investments are volatile, particularly over the short term, over the longer term the stock market has consistently outperformed building society investments. Although shares are still riskier in some respects, extending the time involved in the investment changes the picture. Generally, building societies provide a more secure investment because interest is added to the investment and the capital is not put at risk at any point. Even if the building society were to pay no interest, the capital would be secure – but building society accounts pay interest at low rates, often not even equal to the rate of inflation. Stock‑market‑linked investments are termed ‘asset‑backed’ investments because their value is backed by the value of the assets underlying the shares or investment. The assets themselves may increase in value; they may also lose value. Over the longer term, asset‑backed investments are more likely to provide protection against inflation. This is an important concept when making recommendations to clients. Deposit‑based investments may be more appropriate if a client’s investment objectives are short term, but asset‑backed investments will generally be more appropriate for the longer term, as we will see in section 7.2. 7.2 The equity risk premium The term equity risk premium (ERP) is used to indicate the difference between the performance of equities and low‑risk investments (government bonds) in relation to the risk taken by investing in equities as opposed to the relative safety of bonds. 246 ©LIBF Limited 2024. All rights reserved. 7.3 Types of risk FACTFIND The following resource from Credit Suisse provides recent information and analysis on global investment returns and risks: www.credit-suisse.com/about-us-news/en/articles/media-releases/credit-suisse- global-investment-returns-yearbook-2021-202103.html The BlackRock Return Map mentioned in section 4.7.1 is another resource that demonstrates the differences in performance between different asset classes over a period of years: www.blackrock.com/corporate/insights/blackrock-investment-institute/ interactive-charts/return-map The following graph from Vanguard traces asset class performance back to 1991 and includes additional information alongside the historical returns: www.vanguard.co.uk/content/dam/intl/europe/documents/en/vanguard-2022- index-chart-uk-en-end.pdf 7.3 Types of risk At a high level, we can think about risk as falling into one of several categories, including the following: investment risk – the probability/likelihood of achieving/failing to achieve the expected return on any particular investment; operational risk – risk of losses stemming from inadequate or failed internal processes, people and systems, or from external events; business risk/reputational risk – the exposure that a company has to factors that will lower its profits/earnings. There are, however, many ways that different risks can be categorised. When we think about investment risk, we can further subdivide this into a number of categories, each of which we will consider in turn: capital risk; income risk; shortfall risk; liquidity and access risk; interest risk; inflation risk; currency risk; systematic and non‑systematic risk; gearing. ©LIBF Limited 2024. All rights reserved. 247 7: Risk 7.3.1 Capital risk Capital risk is generally understood as the risk of losing some, or all, of the original investment. For example, the value of shares in certain UK banks plummeted as a consequence of the banking crisis and the credit crunch in 2008/09. The only way to avoid capital risk is to invest in deposit‑based accounts, although that introduces another risk – inflation risk. 7.3.2 Income risk Income risk comes in two forms: There is a risk that the income from an investment will reduce in notional terms. This is particularly the case with products that have a variable rate of interest, since a reduction in general interest rates may lead to an income reduction. It may also occur when a company reduces dividends paid on shares due to reducing profits or other problems. There is also the risk that the income generated from an investment will not keep pace with inflation. This is particularly the case with fixed‑income vehicles such as annuities and fixed‑interest gilts, where increasing inflation over time will reduce the spending power of the income. 7.3.3 Shortfall risk There is a risk that an investment chosen for a specific purpose may not meet expectations. For example, many investors who took out endowments to support an interest‑only mortgage have been warned that their endowments are unlikely to match the mortgage amount on maturity. While riskier investments might offer the potential for better growth, they also pose a higher and less predictable shortfall risk. Safer investments, such as deposit accounts, are less likely to result in a shortfall, but a much higher amount will need to be invested at the start. This is because a lower growth rate will be assumed at the start when calculating how much to invest. 7.3.4 Liquidity and access Liquidity refers to an investor’s ability to turn an investment into cash quickly if required. For example, blue‑chip shares are more liquid than commercial property; shares can be sold quite quickly, while the sale of a property can be a long process. On occasions it may be possible to turn an asset into cash quite quickly, but only by reducing the price significantly. A good example would be the housing market, where a property owner wishing to sell quickly is often advised to reduce the asking price to attract buyers. Another liquidity factor is the price of the asset. One of the reasons why property is seen as an illiquid asset is the sheer cost of buying it, which immediately limits the number of prospective purchasers. Much the same is true of high‑priced shares – small investors might baulk at buying shares priced at £30 because the perception could be that they would not be getting much for their money compared with shares priced at £5. Apart from appearing expensive, high prices also limit the investor’s ability to diversify their investments. 248 ©LIBF Limited 2024. All rights reserved. 7.3 Types of risk Liquidity is not always obvious; having said that shares are quite liquid, certain shares have limited markets and may be difficult to realise – examples would be venture capital trusts and unlisted securities. Those wishing to invest in illiquid assets may be better advised to invest via collective funds, where cash is kept in reserve to cover day‑to‑day cash flows. However, even collective funds sometimes have liquidity problems. It is common for property unit trusts to reserve the right to defer payments to investors selling for up to six months, sometimes longer, in order to make sure that they do not have to sell assets at knock‑down prices to provide the cash. Liquidity relates to the practicalities of realising cash from the asset. Access relates to the investor’s ability to gain access to their funds. Many investments, including some cash‑based accounts, are arranged over a fixed term, and do not allow access to the investment until the end of the term. More commonly, the investor is able to access the investment but only on payment of a penalty or the loss of a specified amount of interest. For example, most structured products do not allow access during the term, while most fixed‑rate deposit accounts penalise early access by deducting 30 or more days’ interest from the account. 7.3.5 Interest risk Interest risk can show itself in two main ways. Savers in variable‑rate accounts run the risk that the interest rate will reduce. This is a particular risk for those who have retired and depend on savings to supplement their income. Those saving in fixed‑rate savings accounts with penalties may receive a lower rate relative to the market if rates increase, but will be unable to withdraw their money without penalty. 7.3.6 Inflation risk There is a risk that inflation over time will reduce the real value of capital and the buying power of the cash saved. Investors should look for investments that are likely to provide a real return over time. For example, assume inflation averaged 2.1 per cent a year for a five‑year period. If an individual had put £1,000 in a non‑interest‑bearing current account at the start of the period and left it for five years, it would buy £902 worth of goods. In order purely to maintain the purchasing power of the cash, a basic‑rate taxpayer would need to achieve an average annual return of 2.63 per cent gross. Put another way, in order to buy the same amount of goods at the end of the period, the £1,000 would need to have grown to £1,120. Conversely, borrowers tend to benefit when inflation is high because the real ‘value’ of their debt reduces over time. Those with interest‑only loans will require less in real terms to pay off the loan at the end of the term. Very low inflation is not seen as a positive situation; a figure of 2 per cent inflation is seen as healthy and necessary for a growing economy. Deflation could lead to problems in the economy because, in such situations, people postpone buying goods in the hope that prices might reduce further, and company debt grows in real terms. Traditionally, the Bank of England would decrease the Bank rate to stimulate the economy. One of the potential problems with using interest rates to control inflation is that changes take some time to filter through. For example, looking at the CPI over ©LIBF Limited 2024. All rights reserved. 249 7: Risk 12-month periods, after the increase in August 2016 it took until February 2017 for inflation to move above 2 per cent, peaking at 3.1 per cent in November 2017. There followed a period of gradually falling inflation (disinflation) and by July the CPI stood at 2.4 per cent. In a move to combat fears that high levels of employment would lead to wage inflation which, in turn, would affect general inflation, the Bank of England raised interest rates again. 7.3.7 Currency risk Where an investment is made overseas or in a fund that invests overseas, there is currency risk: the risk that currency fluctuation might erode the value of the investment. When sterling rises in value against the foreign currency, it has the effect of reducing the value of the investment in sterling terms. Conversely, when sterling falls against the foreign currency, the value of the investment rises in sterling terms. This phenomenon is the opposite of debt calculations, in which a fall in sterling increases the sterling equivalent of a debt held in a foreign currency. It would be useful to see how this works in practice. Graham bought a property in Spain in January 2005, valued at €100,000, and would have bought at an exchange rate of €1.43 to the £1, resulting in a sterling cost of £69,930. We will ignore purchase costs and the significant fall in Spanish property prices for the purpose of the examples and will base all calculations on the bank exchange rate, which is likely to be higher than the rate available to most individuals. Graham decided to sell the property to Bryony at the start of 2011 for €100,000 and move back to the UK. Graham would receive an exchange rate of €1.10 to £1, giving him £90,900 – a handsome sterling profit on a property that did not increase in value. Bryony’s €100,000 purchase cost her £90,900. In fact, Graham could have sold the property for €71,000 at an exchange rate of €1.10 and still have got back his original sterling outlay, even though that would represent a 29 per cent loss on the original euro price. However, if Bryony decided to sell in January 2016, when the exchange rate was €1.30 to £1, she would receive the sterling equivalent of £76,923 – a loss of £13,977 purely on exchange rate changes. The house would need to increase in value by 18 per cent for her to break even on her purchase cost. As a result of the June 2016 EU referendum, sterling fell significantly against the euro and in November 2018 was at €1.14 to £1. This would mean that, if Bryony had decided to postpone selling until then, she would receive the sterling equivalent of £87,720, reducing her potential loss to £3,180. 7.3.8 Systemic, systematic and non‑systematic risk The possibility of systemic risk is an important factor in event risk and can generally be explained as the risk that a failure by one participant in a system to meet its contractual obligations will cause other participants in the system to default too, creating a chain reaction or domino effect that leads to broader financial difficulties and puts the system itself at risk. The failure of a large financial institution that owes large amounts to other institutions would cause the other institutions to fail in turn, since their assets would turn into bad debts and they would not be able to honour their obligations to others. The failure of Lehman Brothers in September 2008 had exactly this effect, and it was to 250 ©LIBF Limited 2024. All rights reserved. 7.3 Types of risk avoid systemic risk that several governments rescued banks that would otherwise have crashed. Systemic risk is greatest when: different organisations within the system are highly interdependent; the organisations are closely interrelated through their transactions with each other. The main sources of concern for systemic risks are banking and insurance. Banks are highly geared – they have large amounts of liabilities relative to the amount of their own capital. There is a high need for liquidity. There is high interdependence between banks (for instance from interbank lending and deposits, and from common payments systems). This applies not only within a country like the UK but also on an international scale due to the global nature of modern financial operations. There is potential for a ‘run’ on the banks, leading to large withdrawals of money by customers. Systemic risk in banking is therefore a risk that affects the entire financial market or system, not just specific participants. Systematic risk is sometimes known as market risk. It is the risk that events within the financial system, the economy or markets in general may cause share and other asset values to fall significantly due to reduced confidence, although the majority of companies remain solvent. While some companies and sectors may be affected more than others, the problem is general rather than specific to certain businesses. Examples would be wars, recession, inflation or interest rates. The entire market is affected by the event, so it is not possible to reduce the risk by diversification. The key difference between systemic and systematic risk is that systemic risk begins with the impact on a specific business or group of businesses and spreads through the wider market because of the interlinkages between businesses. Systematic risk springs from an event external to the market that affects the entire market. Non‑systematic risk relates to specific sectors and investments. It is the risk of a particular share failing to deliver expected returns, or collapsing due to factors more to do with the company or companies in a specific sector than the markets or economy in general. For example, the announcement in the 2014 Budget that people would no longer have to buy an annuity with the proceeds of their pension pot had an immediate adverse impact on the share price of annuity providers. Non‑systematic risk can be diluted by diversifying the portfolio over a number of companies’ shares, or over a number of market sectors. For example, the sensible investor might invest in a selection of banks, builders, telecoms and engineering shares rather than put everything in one telecom company. If the telecoms sector performs badly, they have a cushion provided by the other shares. 7.3.9 Gearing Gearing is the term used when a company borrows to invest, and the level of gearing is usually expressed by showing the borrowing as a percentage of capital and reserves. Gearing is sometimes referred to as leverage. It is particularly relevant to investment trusts, which are collective investment schemes set up as companies and so able to borrow to invest. Investment trusts are detailed in Topic 12. ©LIBF Limited 2024. All rights reserved. 251 7: Risk The higher the proportion of debt to the capital and reserves of the company, the more volatile the investment. The investment trust manager borrows the funds to buy assets that they feel are likely to increase in value. As a result of the initial purchase, the fund will see an initial rise in asset value, created by the additional assets. Put simply, over the longer term, if the assets grow at a higher rate than the interest paid on the borrowing, the investor wins through increased dividends, share price or net asset value (NAV). The NAV can be defined as the value of the investment trust’s assets, less liabilities, divided by the number of shares. If the assets do not outpace the interest paid, the NAV of the shares will fall. Gearing increases the volatility of the investment, because the effect of a fall in the value of assets bought with borrowing will be made worse by the effect of the interest payments on the overall picture. Net asset value (NAV) The Wonderful Investment Trust has 10m shares issued, and assets of £15m, giving a net asset value per share of £1.50. If we assume that the assets grow by 20 per cent, the increase would lead to a NAV of £18m/10m shares = £1.80 per share – an increase of 20 per cent. Let’s assume the trust borrows £3m for a specific investment, with an interest rate of 7 per cent. The trust would have 20 per cent gearing and would have to service the annual interest payments of £210,000. The assets will have to rise by more than that figure to increase their real value to the trust. Prior to the borrowing, the NAV would be £15m/10m shares = £1.50 per share. The assets bought with the loan would increase the trust assets to £18m, with debts of £3m. This would give asset value of £18m less £210,000 interest = £17.79m. The NAV would be £17.79m, less £3m loans = £14.79m/10m shares = a new asset value of £1.479 per share. Assume the trust assets grew in value by 20 per cent. This would give an asset value of £21.6m less interest payments of £210,000 = £21.39m. The NAV would be £21.39m less £3m loans = £18.39m/10m shares = £1.839 per share. This represents a growth in NAV of 24.3 per cent. Assume this time that the value of the assets falls by 20 per cent. This will give an asset value of £14.40m less interest payments of £210,000 = £14.19m. The NAV would be £14.19m less £3m = £11.19m/10m shares = £1.119 per share. This represents a fall of 24.3 per cent. If the company had not borrowed, the 20 per cent asset fall would have resulted in a new NAV of £12m/10m shares = £1.20 per share – a fall of 20 per cent. The net effect is that gearing will accelerate growth and worsen a fall. As you can see, the higher the level of gearing the greater the effect either way and the higher the risk. 7.4 Other considerations We have looked so far at the types of risk that an investor might face. We can now focus on a number of other factors that are important when considering investment risk. 252 ©LIBF Limited 2024. All rights reserved. 7.4 Other considerations 7.4.1 Volatility Volatility is an important factor when assessing the suitability of an investment. It measures the fluctuation in value of a share or fund. Simply put, volatility indicates how a particular share or fund has fluctuated over a set period when compared with its previous performance, the average in its sector or a specified benchmark. The volatility of a share or fund is measured by its standard deviation from the average or benchmark return, known as the ‘expected return’; the more the fluctuation, the more volatile the investment. The standard deviation is a mathematical method of measuring the spread of a set of values around a mean. To take a non‑financial example, if we measured the height of a class of schoolchildren, we could work out the mean (average) height easily. However, the mean would not tell us if there were variances in individual height – some would be much taller or shorter than the mean. Standard deviation would help us to see the spread of heights and how they compare to the mean. If a share’s performance stays close to the expected return from year to year, it has a low standard deviation and is said to have low volatility. For example, returns from an investment with a standard deviation of 1 and an expected return of 5 per cent would be expected to fluctuate between 4 per cent and 6 per cent, which represents low volatility. If the investment performance varies greatly from the expected return from year to year, it has a higher standard deviation and would be ‘volatile’; in general terms, the higher the volatility, the higher the potential risk. Most fund managers are looking for consistency because higher volatility usually means higher risk than the average. The perfect investment, of course, would be a fund with high returns but low volatility – the manager of such a fund would be much sought after. Benchmarks used could be a stock market index such as the FTSE 100, an average of similar funds or other indices compiled by investment statisticians. The benchmark sets the expected return from the investment, against which the volatility can be calculated and the range of potential returns predicted. The data used to assess volatility will be historical, which means that future volatility predictions cannot be precise. For example, a fund with a standard deviation of 3 is measured against a benchmark that has an expected return of 5 per cent a year. This means that the range of expected returns for the fund would be between 2 per cent and 8 per cent a year. Another fund has a standard deviation of 10 and is measured against a benchmark with an expected return of 8 per cent. This would lead to a range of expected returns between minus 2 per cent and 18 per cent. Clearly, the second fund is more volatile; although it offers high potential returns, it also has a significant downside potential. On occasions, two shares might indicate similar expected returns but have different standard deviations. Common sense suggests that an investor should select the less volatile share, because they could achieve the same potential return with less risk. It is generally thought that, in a normal distribution curve, around 68 per cent of the data is contained within 1 standard deviation of the mean (benchmark), around 95 per cent within 2 standard deviations and almost 100 per cent within 3 standard deviations. To give an example, if a share has an expected return of 10 per cent and a standard deviation of 15 we can predict that: roughly 68 per cent of the time the return will be within one standard deviation – minus 5 to plus 25 per cent; roughly 95 per cent of the time the return will be between two standard deviations – minus 20 per cent to plus 40 per cent; ©LIBF Limited 2024. All rights reserved. 253 7: Risk 99 per cent of the time the return will be between three standard deviations – minus 35 per cent to plus 55 per cent. Of course, it must be stressed that the volatility calculations and the predicted returns are by no means guaranteed and are based on a number of factors that could change. 7.4.2 Measures of volatility When deciding on the level of risk to take, an investor should look at the potential total return they will gain from the investment. The total return is the total amount of value to be gained, which will be the total of capital gains plus dividends received. The two main measures of volatility are beta and alpha. Beta shows how a share or fund fluctuates against the market, while alpha measures the level of return in relation to the risk taken. We will look at beta factors before we look at alpha, since it is important to understand beta before we consider alpha. 7.4.2.1 Beta factors Beta factors measure the volatility of a share or collective fund against the whole market or against a benchmark such as a specific FTSE index. The beta measures are: beta factor 1 – where the holding moves in line with the index or benchmark, which is assumed to have a beta of 1; beta factor over 1 – where the holding fluctuates more widely than the benchmark, making it more volatile and more risky than the benchmark; beta factor below 1 – where the holding fluctuates less than the benchmark. A cash‑based investment has no direct links with the stock market and so would have a beta close to 0. The higher the beta, the more volatile and risky the investment. Even where the investor has diversified the portfolio, if the average beta of the investments in the portfolio is above 1, the portfolio is riskier than the market in general. Example If a fund has a beta factor of 2 and the benchmark increases by 2 per cent, the fund or share is likely to increase by 4 per cent. If the benchmark loses 2 per cent, the fund or share is likely to lose 4 per cent. If the fund or share has a beta factor of 0.5 and the benchmark moves up by 2 per cent, the fund or share is likely to increase by 1 per cent. If the benchmark loses 2 per cent, the fund or share is likely to lose 1 per cent. The beta factor is compiled using historical data. This means that the situation can change in the future, particularly where a collective fund changes manager. 7.4.2.2 Alpha performance measurement Alpha is a term used to measure an asset’s return on investment compared to the risk‑adjusted expected return. The expected return is based on a benchmark, usually an index, or on the expected return using the Capital Asset Pricing Model (CAPM). CAPM is a model used to determine the expected return on an investment given the risk taken. The 254 ©LIBF Limited 2024. All rights reserved. 7.4 Other considerations calculation is based on the excess return: the actual return of the share (or the index) over and above the short‑term interest rates. For example, if a share grew by 14 per cent and the short‑term interest rates were 4 per cent, the excess return would be 10 per cent. The formula for calculating the alpha is: AR – {RF + FB (RM‑RF)} AR = actual fund return RF = risk‑free return FB = fund beta RM = market return If the return from the share is higher than the benchmark’s risk‑adjusted return, it has a positive alpha. This means that the additional risk is worth taking. If the return from the share is lower than the benchmark, it has a negative alpha, which means the risk is not worth taking. Example Acme Equity Fund grew by 14 per cent while short‑term interest rates were 4 per cent; this gives an excess return of 10 per cent. In the same period, the benchmark grew by 10 per cent, giving an excess return of 6 per cent. Multiply the excess return over the benchmark by the share’s beta of 1.5. This gives a figure of 9 per cent. This means that the share’s alpha is +1 per cent – a positive alpha. Using the equation gives us: 14 – {4 + 1.5(10‑4)} = 1 As with most investment figures, alpha, beta and total return statistics are based on historical data. Changes to the company or fund strategy can have a significant effect on future returns and should be considered in tandem with all relevant information. 7.4.3 The time value of money The concept of the time value of money is that money has a value depending on when it is received or paid. It can be used to compare investments and a range of other financial transactions. If an individual has the choice of receiving money now or at some point in the future, it is clearly better to take it now, because it can be invested and make a return. Alternatively, there must be some type of compensation if receipt is to be delayed. If £1 received today could be invested at 5 per cent, it would be worth £1.05 in 12 months’ time; £1.05 would be its future value. In the same way, a promise of a payment of £1.05 in 12 months’ time would have a present value of £1. The main implication is that a single sum of money or a series of equal, evenly spaced future payments or receipts can be converted to an equivalent value today. Conversely, the future value of a single sum or series of payments can be calculated. This has a number of potential uses. An investor who wishes to accumulate a £10,000 lump sum in five years’ time can calculate the amount that will need to be invested today. An investor with £10,000 to invest today can work out what it will be worth in five years’ time. ©LIBF Limited 2024. All rights reserved. 255 7: Risk Someone with a lump sum sufficient to pay off an existing debt can calculate whether repaying the debt now will be a better choice than investing the money and repaying the debt at its normal repayment date. Someone with a lump sum sufficient to pay off an existing debt can calculate whether to seek a discount for early repayment. For example, assume Jon has £15,000 in the bank earning 3 per cent a year and a £10,000 interest‑free debt due for repayment in 12 months’ time. If Jon used £10,000 of his capital to repay the debt now, he would lose out on 3 per cent interest on the capital over the next 12 months. In addition, the lender would be able to earn £300 interest on the capital. In reality, if Jon offered to pay £9,709 now: — the lender could invest the £9,709 at 3 per cent and end up with the same £10,000 it would have received after 12 months (it would also free up the capital for other uses or more lucrative investment); — Jon could invest the £291 saved at 3 per cent, resulting in a final sum of £300 – a £9 profit compared to paying off the loan on schedule. In order to calculate the present or future value of money, you will need to know any four of: — the interest rate; — the payment(s) amount; — the number of payment periods (monthly, annually, etc); — the present value; — the future value. In order to calculate the present or future value, you can either use compound interest tables, as described in section 7.4.3.1, or mathematical formulae and a calculator. 7.4.3.1 Compound interest and discounting Compounding and discounting are the methods used to establish the present or future values of money. Simple interest is the term used when interest added to an investment is based on the original capital each year. For example, if Dave invested £1,000 today and it earned 4 per cent interest each anniversary, he would receive £40 each anniversary. His investment would be worth £1,040 on the first anniversary, £1,080 on the second and £1,120 on the third. Compound interest is the term used when interest earned is added to the capital and earns interest itself. For example, if Dave’s account paid compound interest, he would have £1,040 on the first anniversary, £1,081.60 on the second and £1,124.86 on the third. Although we have used the term ‘interest’ so far, we can also apply the same basis to any other type of percentage return, such as capital growth. It is not necessary to learn the mathematical equation for calculating compound returns; simple compound interest tables will do the job perfectly well. Tables are available for calculating the returns on a lump sum over a number of years or for regular monthly or annual ‘premiums’. For example, to calculate Dave’s return at a constant 4 per cent a year over 20 years, we would use the ‘single unit principal’ compound interest table, which would show that for 256 ©LIBF Limited 2024. All rights reserved. 7.4 Other considerations 4 per cent over 20 years, we would multiply the initial capital sum by 2.19112, giving a compound return of £2,191.12. Discounting is the opposite of compounding, and can also be calculated using compound interest tables. Discounting is used when we need to work out how to invest now in order to achieve a target sum in the future. For example, Annette would like £15,000 in eight years’ time to pay for her son’s university fees. She thinks she could achieve an average return of 6 per cent a year on the type of investments she would choose. Discounting the target sum by 6 per cent each year over the eight‑year period will give her the amount she needs to invest now. Again, using the ‘single unit principal’ compound interest table, we would work out the factor for 6 per cent over eight years, which is 1.59385, but this time we would divide the target by the factor. In this case the required sum for investment now would be £9,411.17. 7.4.3.2 Real and nominal returns When a deposit account offers an interest rate of 5 per cent, it is quoting the nominal rate of return, which is the actual rate paid but takes no account of inflation. However, inflation will reduce the value of any interest paid in real terms. We need to do some calculations to find out the true value of the interest. We can work out a rough indication by taking the rate of inflation from the interest rate. So, if the nominal rate of interest is 5 per cent and inflation is 3 per cent, we could say that the real rate of return is roughly 2 per cent. However, this is not exact, so to find the true real rate of return we use this formula: (1+ the nominal rate) divided by (1+ inflation rate) – 1. A single figure nominal rate (between 1 and 9 per cent) is expressed as 0.01, 0.05 and so on. 5.5 per cent would be expressed as 0.055, 3.25 per cent would be expressed as 0.0325, and so on. A double figure nominal rate (10% to 99%) is expressed as 0.10, 0.25 and so on. In the example above it would be: 1.05/1.03 = 1.0194. 1.0194 – 1 = 0.0194 × 100, which is 1.94% real rate of return. Even the real rate of return may not show the total picture. In the example above, once the personal savings allowance has been used, a basic‑rate taxpayer would pay basic‑rate tax on the interest, reducing the nominal rate of return to 4 per cent, giving a net real rate of return of 0.97 per cent. The net rate for a higher‑rate taxpayer would be nil – 3 per cent after tax less 3 per cent inflation. For this reason, prudent investors seek investments that will provide positive real net rates of return. 7.4.3.3 Pound cost averaging Pound cost averaging is an approach used by some investors to spread their investment out, so rather than buying all their investments in one go at one price, they drip feed their investments into the market in instalments over time. Some investors may have cash to invest all at once but choose not to do so, whereas others may have excess cash to invest over time (eg from a salary). ©LIBF Limited 2024. All rights reserved. 257 7: Risk Pound cost averaging ultimately means that the level at which an investor buys assets is averaged out. It seeks to provide some protection against the possibility of the market dropping sharply shortly after investment – instead of the full investment suffering a loss, only the invested portion is affected. The remainder of the investment is then invested at lower prices. In this way, pound cost averaging can be effective in a falling market. However, if markets go up then with pound cost averaging buying takes place when prices are increasing rather than declining, which would be an inefficient strategy. Another potential drawback of pound cost averaging is that it may alter the asset allocation of an existing portfolio until the total amount is fully invested. Reverse pound cost averaging is the opposite of pound cost averaging. Rather than investing at regular intervals, it refers to taking the same amount of money out at regular intervals (ie drawing down). Although the same amount is taken out at each interval, the assets that will need to be sold to provide these redemption proceeds will vary and if the value of assets moves down then the investor will lose out. The idea behind reverse pound cost averaging is to sequence risk rather than waiting and withdrawing or drawing down a large amount at a single point. However, volatility can cause the investor to lose out if they are seeking to obtain a fixed drawdown each year to provide an income (eg in retirement). Topic summary The nature of investment risk, customers’ attitudes towards it and ways to reduce it have long been a key part of investment planning. In this topic we looked at: — liquidity and access; — income and capital growth; — short‑term volatility; — long‑term investment performance; — specific types of risk; — systemic, systematic and non‑systematic risk. 258 ©LIBF Limited 2024. All rights reserved. Review questions Review questions The following questions are designed to consolidate and enhance your understanding of the material that you have just studied. Answers to the questions are contained at the end of this book. 1. Explain the term ‘equity risk premium’. 2. Daphne has £20,000 invested in shares in two telecom companies. Other than that, she has £5,000 in the building society. What particular risk is Daphne exposed to? How could she reduce that risk? 3. Blatant plc shares have an expected return of 12 per cent a year and a standard deviation of 15. Subtle plc shares have an expected return of 8 per cent a year and a standard deviation of 12. Calculate the range of returns for each share 68 per cent of the time, and state which share is more volatile. 4. What measure establishes, in simple terms, if an investment risk is worth taking? ©LIBF Limited 2024. All rights reserved. 259 7: Risk 5. A fund has a beta of 1.2, short‑term interest rates are 3 per cent and the fund’s benchmark rises 7 per cent. What would be the expected return of the fund? Assuming the fund achieved the expected rate of return, calculate its alpha. 6. Find a set of compound interest tables on the internet or through another source. Alternatively, use a scientific calculator. Calculate the compound return of: a) an initial investment of £1,200, invested for 12 years at an average growth rate of 8 per cent; b) a regular investment of £600 a year every year for 10 years at an average growth rate of 6 per cent pa. 7. Harry needs to provide a lump sum of £15,000 in nine years’ time. Assuming an average growth rate of 7 per cent, how much would he need to invest today to meet his target? (Use compound interest tables or a scientific calculator to work out your answer.) 260 ©LIBF Limited 2024. All rights reserved.