≡ Menu

Investing for beginners: Uncompensated risk

Investing lessons are in session

The relationship between risk and reward is a cornerstone of understanding long-term investing.

As we saw in a previous lesson, the various asset classes – cash, bonds, property, equities and so on – sit on a continuum of rising risk and reward.

  • Cash is the least risky asset class – it’s often considered risk-free – but you also expect the lowest return from it.
  • Bonds are riskier, and over the long-term their historical returns have been higher than from cash.
  • Equities are the riskiest mainstream asset class. They’ve typically delivered the highest returns over the long-term.

Remember that when we say ‘risk’ here, we mean volatility – how much prices move around – although the risk most of us care about more – losing some or all our money – also applies.

Another – non-academic – way to think about risk is it’s the probability of something being worth less than you paid for it at some point in the future.

Cash in a bank never goes down in value. Shares can fall 5% in a day and crash 50% in a matter of months in a bear market, though that’s rare. But over the very long-term the returns from shares can be expected to trounce cash.

Why does this relationship hold? Because it has to.

Why risk taking usually pays in investing

If you think about it, why would anyone invest in a riskier asset class if they only expected to get the same return as from a less risky asset class? (And the latter with better sleep and fewer grey hairs, too.)

The odd person might make misguided bets.

But the market as a whole is considered to be rational and efficient, not an Edward Lear poem.1

If a riskier asset class appears to offer only the same return as a less risky one, then something has to give. The price of the riskier asset falls until it is cheap enough to offer sufficiently enticing expected returns to make up for its extra volatility.

  • Why would you put up with fluctuating bonds prices if you don’t expect higher returns than from cash?
  • Why risk the vertiginous death swoons of the stock market if you only expect to earn the same returns as from more stable bonds?
  • Zooming into specific shares, why invest in a risky start-up company if you only expect to get the same return as from an established blue chip?

In every case the answer is your expectation of higher returns.

In general the market does a good job of sorting out the pricing of various asset classes at any time to match buyers and sellers at the different risk/reward points.2

We investors can then bolt together portfolios from the different asset classes with the aim of matching our overall risk tolerance.

But here comes the important point. Academics – who came up with all this theory – warn that the relationship of more risk, more reward does not always hold.

In some circumstances you take greater risk, yet you can’t expect the market gods to reward your chutzpah with greater returns.

Academics call these lousy bets uncompensated risk.

Uncompensated risk: Just say no

The classic example of uncompensated risk is buying shares in an individual company versus investing in the broad stock market.

Let’s say you expect shares in financial blogging firm Monevator Industries to deliver a 10% annualized return over the next decade.

Suppose you also believe the wider stock market will return 10% a year.

Now, there are many quirky things that can go wrong with Monevator Industries on the way to you earning your 10%.

  • It could suffer an industrial accident.
  • Its products could go out of fashion.
  • Its CEO could buy a new apartment and get distracted from running the business.
  • It could go bust.
  • At the very least its price is likely to move around a lot to reflect the market’s shifting assessment of these factors.

Of course, the stock market as a whole will also go up and down, too. Its various constituents will have their woes.

But all companies in the market should not suffer the same business disasters at exactly the same time.

If you’ve got all your money in one stock, you’re therefore taking on a lot more risk than the market – including the risk of losing all your money.

But don’t panic! Holding more than one company immediately diversifies your portfolio, and reduces this risk.

And the more additional companies you hold, the more the company-specific risk is diversified away.

Estimates vary, but holding as few as a dozen-to-20 different shares3 gets rid of the bulk of the company-specific risk. By the time you’re up to 50-100 different holdings you’ll have to hunt for the decimal point.

At the extreme you can just buy the whole market via an index tracker fund. Now you have diversified away all the company-specific risk. You’re just left with the risk of holding equities as an asset class.

Why uncompensated risk doesn’t pay

According to that academic relationship between risk and reward, a risk that can be easily diversified away cannot be expected to reward you with higher returns.

Why?

It goes back to supply and demand.

If investors can reduce the risk of investing in any single accident-prone company by holding a bunch of them, then the risk of investing in companies isn’t such a big deal, after all.

Investors therefore won’t demand so much extra expected return to entice them to buy. They’ll take lower returns and diversify.

Because the risk of holding a few individual companies can be easily diversified away like this and not be expected to give you higher returns, it is said to be uncompensated risk.4

As a consequences, you should not expect to earn higher returns simply from running a more concentrated portfolio of shares.

Note: I am not saying that you can’t make money investing in a single company’s shares. Clearly you can! You might have put all your money into Amazon shares at a few dollars and now be a multi-millionaire. Similarly, you might have lost everything in failed bank Northern Rock. In efficient market theory you can’t know which will happen in advance. You just know “shit happens”, and that you can diversify away the risk.

Another example is currency risk. This risk of currencies moving against you can be hedged away and the impact nets out over the long-term with a global equity portfolio, so it is considered to be another uncompensated risk.

Active management is a zero sum game that overall reduces returns to investors through fees and other costs. So some argue that it too is also uncompensated risk.

If you buy one fund, you might do better or worse than the market. The more funds you own – the more you diversify – the more that risk goes away.

Eventually this logic takes you back to owning a total equity market index fund, where you expect higher returns compared to a less risky bond fund, but no special extra returns on top.

Key takeaways

  • Generally-speaking, you will only get higher returns by taking on greater risk.
  • However greater risk cannot always be expected to deliver higher returns.
  • Risk that can be easily diversified away is called uncompensated risk.
  • The market doesn’t pay you for uncompensated risk.
  • Index tracking funds that invest across broad asset classes are an easy way to diversify.

This is one of an occasional series on investing for beginners. You can subscribe to get our articles emailed to you. Why not help a friend get started, too?

Note on comments: This series is for beginners, and any comments should reflect that please, rather than confuse or make irrelevant points. I will moderate hard. Thanks!

  1. Sometimes this efficiency breaks down, as behavioural economists such as Nobel Prize winner Robert Shiller have shown. But almost everyone agrees it’s big picture efficient most of the time. []
  2. Yes, it goes crazy sometimes and seemingly gets it wrong – such as when we see market bubbles. Again, that’s a discussion for another day. []
  3. Chosen from different sectors. They can’t all be sausage makers or umbrella factories. That’s not diversified. []
  4. You might expect to do better than the market because you believe you’re a brilliant stock picker, but that’s another – very unlikely – bet altogether! []

Receive my articles for free in your inbox. Type your email and press submit:

{ 46 comments… add one }
  • 1 Accidental FIRE July 4, 2018, 11:06 am

    Good stuff. Another reminder that it’s time for me to pull back on my risk exposure a bit. But I have to sell some equities to do that and I’ve been lazy about it. I’m not gonna pretend I can time the market, but the inevitable correction has to be getting closer every day.

  • 2 The Rhino July 4, 2018, 11:28 am

    is the critical thing here that you believe the return to be the same from both, i.e. 10%?

  • 3 Matthew July 4, 2018, 1:05 pm

    Risk of inflation is uncompensated…

  • 4 Chiny July 4, 2018, 2:29 pm

    Cash is risk free ? Admittedly UK bust banks have been bailed out above the €100k mark but perhaps not next time. How about P2P which many small investors are trying these days.

    Good article, timely for me. I’ve recently been tinkering with my life savings spreadsheet, de-risking wherever possible.

  • 5 The Investor July 4, 2018, 3:51 pm

    @Chiny — You’re talking about credit risk (i.e. where you hold your money, and the risk of you not getting it back) as opposed to the risk of the asset class itself.

    For almost all readers of this blog the FSCS guarantee and cash split across a few bank accounts gets rid of virtually all credit risk.

    But of course there are risks to anything. 🙂 (Inflation is the big one with cash.)

  • 6 W Neil July 4, 2018, 4:06 pm

    @Chiny In the context of asset allocation and risk, P2P can’t really be considered as an allocation to cash. I would suggest it belongs alongside gold or property as another diversifier.

    The other risk with cash at bank is that it is most likely to have a negative return due to inflation, so if held for the long-term, it has low volatility, but almost 100% probability of inflation adjusted losses.

  • 7 dearieme July 4, 2018, 4:19 pm

    “However greater risk cannot always be expected to deliver higher returns.” Spot on.

    From the forums at MoneySavingExpert you’ll see that lots of people seem have become indoctrinated with the belief that taking equity risk entitles them to higher returns. They also have other erroneous beliefs e.g. that cash always loses to inflation, that you must never time the market, and that equities will always outperform bonds and cash, and indeed inflation, over a quite modest number of years.

    Your point about uncompensated risk is interesting. You’ll remember that the authors of The Returns on Everything were rather puzzled that housing seems to return a bit more than equities while being rather less volatile. Have any critics of that paper had anything interesting to say on that point?

  • 8 Matthew July 4, 2018, 4:44 pm

    I think bonds and property could be higher risk than equities at the moment, because if interest rates rise they (along with mortgage lenders) could be stuffed. Housing generally only returns more than equities with leverage, I believe.

    And bonds have limited upside, making them potentially riskier than an equity that returned the same.

    I think in theory equities always should rise with inflation since their assets, and items they sell, are rising with inflation

    Cash is if you hate volatility/risk of loss so much that you’d rather guarantee a loss. But in small amounts you can offset inflation with regular savers etc

  • 9 The Investor July 4, 2018, 6:17 pm

    It’s a common misconception that returns from cash are negative after-inflation. While that’s been abundantly true over the past decade, over the long-term cash has delivered very modest positive real returns. See:

    http://monevator.com/uk-historical-asset-class-returns/

    And that’s before we even get into the special rates commonly available to alert private investors (compared to institutions).

    I believe cash is an excellent asset class for UK private investors to add to their mix:

    http://monevator.com/cash-and-your-portfolio/

  • 10 The Investor July 4, 2018, 6:20 pm

    (Government) bonds are not riskier than equities, although I’d agree they don’t look like attractive investments at this point in time.

    But anyway, as per the nature of this article and my note at the end, let’s not get distracted into talking about our viewd on particular asset classes *right now* in these particular comments please. I will probably moderate out such diversions from here. Thanks! 🙂

  • 11 Matthew July 4, 2018, 6:41 pm

    It’s hard to imagine a higher interest rate world, and it’d change many things, we wouldn’t have to take the same risks, it is slowly happening I think, a return to normality, but it’ll have to be at a snail pace because of all the big mortgage. A whole generation of investors has grown up in a surreal low rate world

    Note I think how bonds are held (individually vs fund) is worth considering, as you trade one type of risk for another

    Likewise volatility vs inflation/not reaching goals is a tradeoff, but volatility is the most apparent to most people

  • 12 Steve21020 July 4, 2018, 6:46 pm

    — “It’s a common misconception that returns from cash are negative after-inflation. While that’s been abundantly true over the past decade, over the long-term cash has delivered very modest positive real returns.” —

    That all depends on how you measure inflation, doesn’t it?

    Many years ago, c.1989, when I worked in France, even the most patriotic Frenchman was making fun of their country’s methods of calculating inflation. Apparently their civil servants were even using the price of flypaper to keep the figures down. Years later, our well-paid Oxford-educated civil servants came up with the RPI. Now, it’s the CPI, a measure worthy of North Korea. It even uses ‘hedonic regression’ to keep the figures low. Personally, I always use RPI and ‘add a bit’ for my own measure of inflation.
    Steve

  • 13 Matthew July 4, 2018, 7:56 pm

    I note that rpi includes mortgage payments (not cpi) so peversely rpi might actually increase as interest rates raise, leaving you to wonder what can actually be done to control rpi

  • 14 Retirement Investing Today July 4, 2018, 7:58 pm

    @Steve21020
    “Personally, I always use RPI and ‘add a bit’ for my own measure of inflation.” At the start of 2015 I started to track every penny I spent accurately. My experience has been that my personal inflation rate bears no resemblance to any ‘official measure’. To demonstrate:
    – 2015 to 2016 spending = +10.6% vs Jan to Jan RPI = +1.3%
    – 2016 to 2017 spending = +7.6% vs Jan to Jan RPI = +2.6%
    – 2017 to 2018 YTD spending = -13.6% vs Jan to Jan RPI = +4.0%
    – 2015 to 2018 YTD spending = +2.8% vs Jan to Jan RPI = +8.1%

    Ability to select alternative products, providers and choices that bring quality of life have given me the opportunity to keep costs below that of the RPI.

  • 15 Naeclue July 4, 2018, 9:01 pm

    Really good article. RIsk is a hard concept as it involves the just as hard concept of probability. Risk is deeply misunderstood even by many “seasoned” investors and commentators.

    On active management, I find it hard to understand how anyone could possibly argue it was not uncompensated risk. You will get a different outcome from the market by buying an actively managed fund, just as you will get a different outcome by buying a single share.

    Currency risk I am not so sure is uncompensated, but I think I understand what you are getting at here. Risk of failure of any one currency can be reduced by holding a basket of currencies, just as risk of failure of a single share can be reduced by holding a portfolio. On the other hand, currency volatility increases risk asset volatility as risk assets are priced in a particular currency. So measured in pounds, Shell shares goes down as the pound appreciates against the dollar as Shell’s underlying assets and income stream is mostly priced in dollars. Is this what you mean when you describe currency risk as uncompensated? Uncompensated when measured from the point of view of one currency?

  • 16 Matthew July 4, 2018, 9:23 pm

    Currency risk could be compensated by rebalancing bonus if you fixed what proportion of each country you want (not what a tracker would do), I reckon currency is most of my volatility, operates within a range and usually isn’t big enough to help/harm

    On inflation I wonder if the use of RPI before 2003 is partly why historical rates were much higher and more wild – since it was always higher, and since mortgage costs were included (so raising rates didn’t necessarily decrease rpi much without rising really high)

  • 17 The Investor July 4, 2018, 9:38 pm

    @All — Seriously guys. 🙂 When I said I would delete off-topic conversation on *this* page, I wasn’t suggesting it be replaced by some random discussion about inflation measures and borderline-conspiracy theories suggesting that a bit of hyper-personal shopping throws 118 years of inflation-adjusted return data into doubt. 😉

    (It’s well worth digging into the huge effort that goes into compiling inflation data before joining the Internet crowd who are forever crying “foul!” at it, especially in the US. If you have and you still think it’s suspect then fair enough, but I think most people see the price of TVs coming down and haircuts going up and think something is off. I’ll try and do an article on this soon so we can have the discussion there. 🙂 I fully agree personal inflation rates matter, well, personally, but they don’t negate the value/reality of global measures.)

    Anyway it may seem drastic to delete a good-natured conversation, but understand I’d like beginners to be able to come to this “beginner lesson” page in a couple of years time and not get sidetracked or even misled by a slew of comments I haven’t got time to reply to individually.

    Hope that explains why I really will be deleting anything not on-topic by this narrow definition (for these ‘beginner’ articles) from here. Cheers! 🙂

  • 18 The Investor July 4, 2018, 9:45 pm

    @Naeclue — Glad you liked it, and cheers for the on-topic comment!

    Currency risk is not compensated both because it can be diversified away (by hedging or by the operations of the companies we invest in and their natural hedges (such as more competitive exports) and also (perhaps more so) because when one person/country ‘wins’ with their home currency, another loses.

    E.g. When the pound falls versus the dollar we lose versus Americans, but when the pound gains versus the dollar we win versus their weakened spending power. All currencies are in pairs like this, and as I say above it all nets out from the perspective of the total global market.

    I am not an efficient markets academic — indeed you’ll recall I’m an active meddler, and a weak believer — so I don’t want to exceed my pay grade here. It’s possible that one or other of the factors I cite above is most/all important, and I’m not stating it as emphatically as I could. But that’s the gist.

    Rule of thumb — if it can be diversified away (from the perspective of international markets, not you or me finding it a hassle to get the appropriate fund for our ISA or whatnot! 🙂 ) then it is uncompensated risk.

  • 19 ChrisB July 4, 2018, 9:57 pm

    Currency risk is very under appreciated.

    If I own a small US domestic stock, I take stock-specific risk which is uncompensated. I also take dollar risk which is uncompensated.

    Even if I recognise the dollar risk, and buy a USD/GBP hedge that just converts my dollar risk to sterling risk: both are uncompensated

    Even those who buy a world tracker take huge currency and uncompensated risk — becuase 60% of the world’s stock capitalisation is US listed and denominated. I guess an even-weighted global tracker may be the best option at removing currency risk, but I’m not sure that exists.

  • 20 Retirement Investing Today July 4, 2018, 9:58 pm

    @TI
    Apologies for going off piste TI. Please feel free to delete this and my previous comment given their off topic nature. I fully understand your wishes to keep the conversation narrow for beginners. A post like this that encourages somebody to start might just change their lives for the better. I know your and TA’s hard work certainly helped change mine.

  • 21 Matthew July 4, 2018, 10:12 pm

    Diversification is the compensation for currency risk, the reason we do it, perhaps?

  • 22 The Investor July 4, 2018, 10:29 pm

    @RIT — Thanks, no worries. I appreciate I try to police this blog’s comments a bit more than most (though I still delete only 0-3 comments most weeks, so not too Draconian!) and that it can be a bit confusing. 🙂

  • 23 Matthew July 4, 2018, 10:51 pm

    I don’t really want to go off topic, but it’s hard to resist things that come up, I wonder maybe if there was some sort of scrapbook page we could take things, or internal message. I was trying to be on topic originally as interest rate predictions alter the expected risk for cash and bonds, so a change in inflation measure changes the behaviour of the boe

  • 24 The Borderer July 5, 2018, 6:13 am

    “If you buy one fund, you might do better or worse than the market. The more funds you own – the more you diversify – the more that risk goes away.”

    I think new investors should be aware that buying a number of active funds that essentially invest in the same thing may not represent diversification.

    According to research published in the CFA Institutes Financial Analyst Journal diversification into a number of active funds may be contra productive. Each active fund manager will try to beat the benchmark by stock selection, so that each active fund’s ‘tracking error’ may be high, but in aggregate these will tend to cancel each other out, so that in aggregate purchasing a number of active funds can essentially represent an extremely expensive index tracker, which can be bought at a fraction of the price of these active funds.

  • 25 Matthew July 5, 2018, 7:09 am

    Just had a thought – dropping uncompensated risk can be what can cause a drop in equities/bonds as interest rates raise – people will shift down the gears as they no longer need to take the same risk

    I think for new people trackers have the benefit of not having to worry about the manager

  • 26 The Investor July 5, 2018, 7:45 am

    @Matthew — You’re possibly getting confused. There is a COMPENSATED risk when you invest in equities. (Academics call this compensation the equity-risk premium). This is the additional return you expect to get over the risk-free rate (presumed to be government bonds) for putting up with the additional volatility (/risk) of owning shares.

    When interest rates rise, this potentially reduces the equity risk premium (because as you do say in your comment, you can now get a higher return from less risky assets). So in theory at some point equities fall to a level which re-establishes the equity risk premium.

    Also, you only know what this equity risk premium was *after* the event, when you look back at the relative returns. It’s not a magic number that you can bank on, or anything like that.

    Anyway this is all about *compensated* risk from owning shares, not the uncompensated risk of being exposed to some particular company’s woes.

    It’s also important to realize none of this happens like clockwork. 🙂 People may keep buying shares at higher prices than they “should” have, but this is only clear in retrospect. (E.g. The dotcom boom, where you could get 6% on cash and government bonds, but people weren’t bothered because they thought shares would keep going up. When you look back at the data, the ‘extra’ return from shares bought in 1999 turned out to be negative for 10-15 years.)

    These articles may be worth reading:

    http://monevator.com/the-problem-with-low-interest-rates/

    http://monevator.com/understanding-the-low-interest-rate-era/

    http://monevator.com/what-is-the-equity-risk-premium/

    http://monevator.com/the-equity-risk-premium-and-you/

  • 27 The Investor July 5, 2018, 7:45 am

    @The Borderer — Yes, that’s true, invest in enough funds and you’ll get expensive-tracker like returns. But you will have done away with uncompensated risk. 🙂 As you know, all this theory comes from the efficient market hypothesis. In this theory, there’s no point buying active funds, because there’s no such thing as Edge. (There are return premiums/factors, but that’s a different thing.) You only get higher returns by taking on more risk. So, for example, to such an academic it would make sense to buy a fund with leverage if you wanted higher returns (more risk, which you can expect to be compensated for) but no sense buying a Neil Woodford fund (because he has no edge, because nobody does.) I don’t agree with the theory that edge does not exist, but most people are better off investing like it doesn’t for sure, and avoid the risk of active managers. (And I do think the efficient market theory is broadly correct, and a useful way to think about things.)

  • 28 Matthew July 5, 2018, 8:53 am

    @ti – it’s the adjustment to the risk premium that I mean, as the old level becomes unjustified as rates rise – right at the moment rates do rise

    I don’t know what would happen if base rate ever exceeds the expected total return of equities, like when it was 17%, I’ll look into that

  • 29 ChrisB July 5, 2018, 9:41 am

    @Matthew
    “if base rate ever exceeds the expected total return of equities”

    That will never happen, at least if you’re comparing gilts with domestic UK equities.

    In theory it may happen if investors feel gilts are more risky than global equities (due for example to UK government default or sterling devaluation risk) but I can’t see even Brexit throwing up that situation. Hmmm, let’s not be too hasty ….

  • 30 YoungFiGuy July 5, 2018, 9:46 am

    Great post TI. I think diversification is one of those counter-intuitive topics. We’re kind of saying: “Buying just the best stuff is worse than buying a mix of the best stuff and less good stuff?” That doesn’t really apply when you’re buying bread from the supermarket.

    One other thought, I’ve always found it easier to explain the difference in asset classes and risk from the other point of view: demand (borrower) rather than supply (investor). It’s a bit simplistic but do bear with me:

    – Cash: The money I borrow is repayable on demand (or within a very short time frame). So any investments or bets I make with that money need to payback immediately and I’ve got to be pretty certain of that payback or I’m broke.

    – Bonds: The money is repayable in the long-term future. So I’ve got a bit more time to payback and can make some riskier bets with my capital in the hope it pays off big in the long term.

    – Equities: The money has an infinite lifespan (or until I run out of money). So I’ve got the most leeway to invest my capital. It means I can take the riskiest bets or the projects which take the longest to payback.

    I know it’s a bit more complicated than that, but I think it shows two important concepts immediately:
    – the relationship between capital risk and time horizon
    – the benefit of diversification within and across asset classes (overall creating a mix of investments your collective borrowers are making)

  • 31 John @ UK Value Investor July 5, 2018, 9:48 am

    “greater risk cannot always be expected to deliver higher returns.”

    Exactly. Or more pedantically, you should only invest in high risk ventures that have a higher “expected return” (Google that term if you’re not sure what it means) but you should not expect to get the expected return.

    So if you play Russian roulette with a six-shooter for six million pounds, the expected return is a million pounds (six million pounds divided by six possible outcomes, one for each of the bullets).

    However, you shouldn’t expect to win a million pounds. You should expect to be dead.

    Or with a more positive example, the expected value of a single roll of a dice is 3.5. Now, you can’t actually roll a 3.5, so you’re never going to get the expected return. Instead, you’ll roll a 1 or a 5 or something else. But, if you roll the dice 100 times then the average of your rolls will very probably be very close to 3.5.

    What does this have to do with the stock market? Well, if the expected annual return from UK stocks is 7% (which it more or less is) then you shouldn’t expect to get 7% next year, or in any year. However, the longer you play the game, i.e. the more years you’re invested, the closer your average annual return will get to that 7% expected return.

    Which is a very long way of saying a) don’t play Russian roulette, i.e. don’t take on investment risks which can result in you losing all your money (or even a significant chunk of it) and b) don’t worry about returns over a single year; focus on the 7% or so expected return you’re likely to get over twenty years or more.

    This probably has more to do with one of Monevator’s earlier lessons, but it’s worth reiterating.

  • 32 John B July 5, 2018, 11:10 am

    @YoungFiGuy your cash borrower perspective is wrong. Most loans are made over long timescales, and borrowers might be miffed if their mortgages were called in 20 years early. Its just the statistics of when people want their cash that allows it to be available on demand or at 1 month’s notice. Bank regulation is all about reserves nominally meeting demand, but the modern multipliers are so high (20*) that you just have to hope the Bank of England/Government step in to stop runs on a bank. It is this regulatory backstop that reduces cash risk.

  • 33 Naeclue July 5, 2018, 11:16 am

    @TI “You only get higher returns by taking on more risk.” Strictly speaking this is not true as there will always be a spread around mean returns, so active managers can outperform by luck.

    @ChrisB “Even those who buy a world tracker take huge currency and uncompensated risk”. Even those who buy a FTSE 100 tracker take currency risk!

    Some uncompensated risk is easy to deal with, single stock risk – diversify, active manager risk – avoid (or minimise) actively managed funds. Currency risk is a tough one though. As I have said the FTSE 100 contains currency risk and large companies frequently make use of all sorts of currency hedges in their operations. Currency risk is difficult to avoid and assess. If someone wanted to avoid all currency risk they would need to work out precisely what currency hedges to make and these would need regular updating as currency risk will fluctuate. I do not think it is desirable to hedge away all currency risk even if one could either as currency risk protects against a large fall in the pound and the consequential inflation. Currency hedging cannot be done for free either.

    I decided to park currency risk in the “too hard” drawer so ignore it as far as my global shares portfolio is concerned. Most of my bond/cash assets are in pounds though. The only fixed income assets I hold that are not denominated in pounds are US Treasuries.

  • 34 Naeclue July 5, 2018, 11:23 am

    Possibly worth pointing out that the FTSE World Index has comparable/slightly lower volatility than the FTSE 100 index and historically has suffered lower falls in major market falls, such as after the dot-com boom and in 2008. So I think the additional diversification must outweigh the obviously higher currency risk.

  • 35 John B July 5, 2018, 11:33 am

    Currency risk is much reduced for indexes comprised of multinationals. The FTSE 100 is a good example, with 80% of revenue generated abroad, there is a strong correlation with the strength of the index and the weakness of the pound. I modified my modelling spreadsheet to use the weighted currency measure XDR/SDR to allow for that, but have ignored it since, as I only ever look at GBP numbers…

  • 36 Matthew July 5, 2018, 11:52 am

    I think ftse 100 volatility is a lot to do with large % holdings, for example a small cap with the same level of currency risk could be less volatile on sunny days

    @John b -I would call mortgages more bond like than cash like, I think the cash example from youngfi probably erred more towards loans/ overdrafts

    I notice generally with the English language it’s easy to misunderstand/ not specify /assume/ get caught up in semantics

  • 37 YoungFiGuy July 5, 2018, 12:04 pm

    @John B – 🙂 a little harsh perhaps! I did caution I was being simplistic, but I wouldn’t say I was necessarily wrong. I do think I could have been clearer in saying that I’m thinking about companies. And I’m of course using the extreme ends: both for cash and equities (who can get away with equity finance in perpetuity without paying out any cash proceeds; though Mr Bezos might like a word!)

    Anyway, just it’s just a simple exercise that doesn’t require thinking about fractional banking 😉

    @ John /UKVI – excellent comment!

  • 38 YoungFiGuy July 5, 2018, 12:06 pm

    @Matthew – thanks! I just excised that bit from my comment. When I’m thinking about cash borrowing for a company, I’m talking overdraft or a line of credit.

    [p.s. TI – I will stop going off-topic now!]

  • 39 Naeclue July 5, 2018, 12:24 pm

    @YoungFiGuy I have to disagree with you about your explanation of risk being simpler. It sounds far more complicated than the conventional explanation. If you hold cash, there is zero risk of capital loss over the following year. If you hold investment grade bonds the chance of say a 10% loss over the following year is lower than if you hold shares. That really is all there is to it.

  • 40 Naeclue July 5, 2018, 12:33 pm

    @John B, I agree with you about the negative correlation between the pound and value of multinationals, UK listed or otherwise, but I disagree that currency risk is reduced by holding multinationals. If you hold a pound the value of it in pounds has zero volatility (zero currency risk), but if you hold a dollar it has volatility (ie risk) when valued in pounds.

  • 41 The Investor July 5, 2018, 1:05 pm

    “You only get higher returns by taking on more risk.”

    Strictly speaking this is not true as there will always be a spread around mean returns, so active managers can outperform by luck.

    Absolutely, there are only so many caveats and addendums one wants to add to each statement. 🙂

    As you and others have said in this thread, nothing is guaranteed to anyone either way, once luck is rolled in. Part two of this article (which for once is already written!) will offer more on risk/return and the fact that you can’t just dial up and *know* you will read across to see the return you *will* get. If only it worked that way! (Of course if it *did* work that way there’d be no risk, really.)

    A couple more articles for any beginners reading but (understandably) not commenting:

    http://monevator.com/passive-expected-returns/

    http://monevator.com/you-cant-bank-on-expected-returns/

  • 42 Naeclue July 5, 2018, 1:13 pm

    @John UK VI, “So if you play Russian roulette with a six-shooter for six million pounds, the expected return is a million pounds (six million pounds divided by six possible outcomes, one for each of the bullets).”

    Completely agree with your comment, but to be pedantic on the above, the expected return is not £1m and you only end up dead with certainty if you don’t get to respin the barrel after each pull. Expected return depends on number of live rounds and whether you spin after each pull of the trigger. The game is not quite so nutty if you do get to respin.

  • 43 Matt July 6, 2018, 7:42 am

    The bank of England / treasury used to target RPIX, which was RPI excluding mortgage interest payments. CPI doesn’t include housing, which made it a mistake to target, I think.

  • 44 Mr Optimistic July 6, 2018, 9:51 pm

    In my particular case, on the verge of retirement, the three big issues which I worry about are inflation, government intervention and liquidity. If I need £50k in a hurry, cash and short term bonds look like the best bet so I have to adjust accordingly.

  • 45 dearieme July 16, 2018, 12:11 am

    “If I need £50k in a hurry …”: do you have a mental picture of why that might be – house repairs perhaps? Or do you take the attitude that risks you haven’t conceived of are still risks so that an accessible £50k would bring a welcome access of security?

    I sympathise with the latter: people are forever claiming that they understand what risks they run. A hae ma doots. It’s the fact that the future is so uncertain that makes it wise to hold some equities. You can’t be certain what they’ll protect you from but you can reasonably guess that they’ll protect you from other things than cash, for instance, will. That’s also an argument for holding some gold, some foreign property, some commodities, and whatnot.

  • 46 Ton July 25, 2018, 11:27 pm

    Hi TI
    I feel the importance of diversification both between and within asset classes cannot be stressed enough. When investing in stocks: invest wide and far, across all industries and nations. Concentrating on a specific industry or geographic area means you run extra risk (in addition to general broad market risk). Whether you can reasonably expect to be compensated for this extra risk is doubtful. This week I came across fine example of why spreading your investments matters.

    Dutch news reported that the AEX-index (Dutch FTSE 100) peaked a its highest point since, hold on.. 2001. Had you invested in 2001 you would have recovered your losses no sooner than 17 year afterwards.
    But it gets even worse. In 2001 the AEX was already in freefall. In 2000 the index was valued 20% higher. So had you invested a year sooner, you would still have a long way to go recovering your losses. Compare that to the global market!
    Sounds like Japan is right on the other side of the Channel. The point to drive home is: spread your investments!

Leave a Comment