There are innumerable investing risks, so here is a bluffer’s guide to the main ones.

Next time you consider an investment, make sure you know which of these risks you’re taking, whether you’re comfortable with it – and whether you’re being offered a sufficiently attractive potential reward to compensate.

The presence of these risks does not mean an investment is a bad one. All investments have at least one of these risks.

What matters is whether price is right for the risk, and whether you understand what you’re getting into.

Note: These aren’t textbook definitions of types of investment risk. They’re meant to get the point across quickly to everyone, not stand up in a court of law.

Business risk

Sometimes used to refer to what I call ‘stock specific risk’ below: that is, the specific risks related to one company’s operations. Others use it to describe risks affecting all companies operating in a particular sector. For example, all fishing boats in the same port are affected by periods of bad weather, however skilled their captain or hearty their sailors. I think ‘sector risk’ describes that better.

Currency risk

The risk that comes through changes in the exchange rate between one currency against another. If you invest in European companies and the Euro collapses versus your currency, then your investment will be worth less in local terms when you bring the money back home (unless your funds are hedged, which costs). Similarly, your repayments on a foreign mortgage will rise as your currency weakens. Currency risk can work the other way of course, to your advantage.

Counterparty risk

This is the risk that someone you’ve entered into an agreement with will default or otherwise screw-up. It’s often not immediately apparent when you make the investment. For instance, the fancy Guaranteed Equity Bond your bank sold you might involve contracts underwritten by an American bank you’ve never heard of that goes bust. Don’t laugh – it happened.

Credit risk

Some people don’t pay what they owe. Nor do some companies. Sometimes even countries fail to cough up. If you’re a good credit risk, that means that banks and others think you’ll pay what you owe. If you’re a sub-prime borrower, they may be more concerned – unless you want a mortgage on a shack in a swamp in Florida in 2003-2007. Credit risk is sometimes called default risk.

Inflation

Ever increasing prices is the reason why nobody ever got rich from keeping money under the mattress (except perhaps the makers of mattresses) and the first reason to invest. It’s not just the low but steady inflation we’ve become used to in recent decades – and that you can plan for – that erodes your returns. If you’re very unlucky double-digit inflation comes out of the blue to crush fixed interest savings. Just ask the nearest German centenarian.

Interest rate risk

The risk that the value of your asset – usually a bond, but also to an extent stocks and other securities – will change in response to changes in interest rates. For instance, if you buy a long-dated corporate bond yielding 5% when base rates are 2%, it will very likely (but not inevitably) fall in price if base rates rise to 4%. A new purchaser would probably demand a higher yield (that is, would pay a lower price) to invest in the same corporate bond, given the risk-free rate was now 4%. A related risk is when you put cash in a fixed rate savings account, or take out a fixed rate mortgage. Your fixed rate will be less or more attractive as the base rate changes.

Liquidity risk

Liquidity is a measure of how easy or hard it is to sell an asset. Cash is very liquid; a house is illiquid. Some small company shares can be easy to sell – just log into your online broker and place the order – but if you try to sell more than the cost of a fancy sofa’s worth the price can plunge, which is another risk of poor liquidity. Money tied up for a year in a fixed rate bond is also illiquid, but that’s a given when you invest. You are accepting interest rate risk, and also the risk that you need your money before the term is up.

Management risk

When you invest in an actively managed fund or investment trust, you take on the risk related to the manager’s performance. He or she may do better than the market, or more likely worse. Using index tracker funds gets rid of management risk. The price you pay with a tracker (for most of us well worth it) is you’ve no chance of beating the market.

Market risk

This is the risk you take for simply showing up and investing in a volatile market. The stock market, the property market, even the market for antique hobbyhorses – all move in their own broad trends, which affect all the assets in that market. You can’t reduce market risk when hobbyhorse investing by buying two different hobbyhorses. But you could buy one hobbyhorse and spend the rest of your money on an antique sideboard. Market risk is sometimes called systemic risk – mainly by pompous people like me.

Political risk

There’s a reason why the Russian stock market usually trades on a lower valuation than Western markets, and why London-listed South African companies may seem cheap. The Russians are experts at the appropriation of private property, while South African companies operate in a beautiful country that politically appears to be going backwards.

Regulatory risk

Political risk for Western economies. The risk that politicians or other lawmakers introduce new rules or costs to an industry or sector that hurts your investment. The growing risk that we might see the election of the most left-wing UK government since the 1970s has hit the shares of energy companies, for example.

Stock specific risk

This is the risk that a particular company goes bust, even while the market sails on regardless, leaving your crappy shares in it floating lifeless in the wake. Companies can fall in price or go bust for all kinds of reasons, from fraud to poor management, though it usually amounts to running out of money. This sort of specific risk is also why fund investors (including passive investors) should spread their money between different companies as their portfolio grows. I even think you should keep some cash in different banks, even if your total balance is below the FSCS compensation limit. Assume anything can fail.

Volatility

In simple terms, volatility is the range over which the value of an asset moves over some time, usually a year (technically, the standard deviation over the return rate). If the price moves a lot, it’s a high volatility asset, whereas if it doesn’t go anywhere quickly, it’s low volatility. Low volatility usually seems more attractive, but higher volatility can deliver superior returns to compensate. Diversification can reduce volatility without denting returns to the same degree. It’s worth considering how closely – or not – academic notions of volatility mirror your own concerns as an investor. (Volatility risk has specific meanings, to do with options or currencies, beyond the scope of this article).

Remember, diversification is your best friend when trying to reduce investing risks. To learn more, please read my article for beginners about risk, returns, time, and diversification.

Investing stories that caught my eye this week.

Where’s your fee-phobic passive investing co-blogger when you need him? That’s what I thought as I read an expose of hidden fees in the Financial Times on Monday.1

In conjunction with the similarly cost conscious Lang Cat consultancy, the FT has totted up the hidden fees on a variety of popular funds, as revealed by the new Mifid II trading regulations.

Mifid II requires funds to go beyond the ongoing charge figure (OCF). They must now also give a total cost, including transaction and trading costs and other charges.

The FT reports:

“…many investors pay almost double the OCF in the UK’s most popular funds once transaction costs are included.

This can go up to four times OCF if platform charges and performance fees are included.”

As you’d expect, some active funds don’t fare well under this particular shaft of sunlight.

For instance the FT highlights the Janus Henderson UK Absolute Return fund, which has an OCF of 1.06%, as well as transaction costs of 0.79%. If platform fees (via Hargreaves Lansdown) and a performance fee is added on, the total annual cost rises to an average of 3.82%.

But tracker funds have also found the receipt to extra charges down the back of their sofa. For example the BlackRock iShares FTSE UK All Stocks Gilt tracker fund has an OCF of 0.2%. With platform fees and transaction costs the cost rises to 0.75%.

Few Monevator readers should be shocked by the platform fee component of the analysis – our broker comparison table has long highlighted that particular burden of investing.

But transaction fees and similar data have been much harder to come by.

As Lang Cat director Mike Barrett says:

“It is grimy that it has taken some EU regulation for asset managers to tell investors what the true cost of investing is…

You have always been paying these fees, but now the fund groups have the good grace to tell you these costs upfront.”

Separately, Andy Agathangelou of lobby group The Transparency Task Force has written to the head of the Investment Association demanding an apology for a previous report from the latter that had claimed hidden fees were the “Loch Ness Monster of investments”.

Further reading:

• “There’s a strangely bittersweet feeling at seeing these figures finally revealed in black and white.” – The Evidence-based Investor

• Hidden investing costs revealed — but ‘still hard to find’ [Search result] – FT

• Vanguard has (now) produced a commendably clear charge sheet [PDF] – Vanguard

• Mifid II and you – Monevator

[continue reading…]

1. The answer, as old hands know, is: “Finishing up the Monevator book. Allegedly”. Watch this space. [↩]

When I bit into the lamb cutlet, I knew I was going to get my money back. I turned to tell my friend Clive but he was tackling some halloumi fries. He gave me a thumbs up.

We were at the launch party of Timmy Green, a soon-to-be trendy eatery near Victoria in London.

A year before I had invested in mini-bonds issued by its parent – a start-up called Daisy Green.

Daisy Green runs Australian-accented cafes and restaurants in London. Back then they made great coffee and great cakes – but little money.

The business was, however, expanding fast. If you squinted a bit you could see strong sales and profits down the line – not least if the mini-bond proceeds helped it to reach scale sooner.

I was a fan of its cafes. I was impressed by the founder. I squinted a bit, and decided to take punt.

A couple of hundred other people did, too, and Daisy Green raised £800,000.

Risky business

Longstanding readers may remember a portfolio of mini-bonds is one of my guilty secrets.1

These so-called ‘Bondi Bonds’ were at the riskier end of this already risky portfolio.

My notes remind me the bonds been assessed as having a 2.3% annual risk of default, which was higher than the other mini-bonds I’d seen rated. I suspected even their 11% yield didn’t fully reflect the risks.

But I was confident in the brand. I judged Daisy Green was going to grow, not go bust. A big reason why I dabble in unlisted bonds and shares is to practice these sorts of assessments. So in I went.

Hey, I also got a load of free coffees!

Bondi beached

Fast-forward to December 2017 and the call proved correct. Daisy Green had doubled revenues and tripled site-level profitability since launching its bonds.

It was doing so well, in fact, that it was able to refinance with a UK bank.

The company said the refinancing represented:

“a significant and early institutional backing of our business which is rare amongst our peers.”

The founders thanked the Bondi Bond holders. The money raised via the bonds – and the support and feedback investors had given the growing company – had been important.

But the upshot was that to obtain the new facility with the bank, Daisy Green had to repay its mini-bonds.

Still, investors got their money back and some high interest payments along the way. The founders were proud to have repaid early. Everyone’s happy?

Not quite.

On a personal level, I was pleased. I like being tangentially involved in start-ups. I was pleased for Daisy Green and its people.

But having taken the risk of investing in the bonds for the reward of that 11% yield over four years, my investment had now been cut down in its prime.

The early repayment was a reminder of a big difference between owning equity and debt.

Where’s my share?

If instead of bonds the company had issued shares to raise money, then the success of the business to-date would have been unambiguously good news for investors.

Equity investors who saw the potential of the brand and the operational qualities of the business would have been rewarded as the story unfolded, because all things being equal the value of their shares would have risen. (They’d have doubled, I reckon.)

But as a bondholder, good news is almost bad news. It’s not quite bad news – default is the worst outcome for a bond holder, and whatever gets you closer to there is what counts as bad news.

Nevertheless, because conventional bonds pay a fixed coupon over time and then return the money you put into them, you don’t materially benefit from an improving company.

Indeed, it can be almost the opposite – as we’ve seen a stronger company can refinance at cheaper rates, cutting existing debt holders out of the picture.

A quick note for bond nerds: I’m talking about a top-level difference between standard equities and bonds here. Yes, you can get special kinds of both with different risk/return characteristics. More pertinently, if you buy a bond when it’s trading below face value, you can get capital appreciation as well as the interest payments should it go on to be redeemed in full. If this happens because the company was poorly-rated when you bought and has now improved, then yes you’ve benefited from the change in status. However your maximum return is still capped – it’s fixed when you buy the bonds. Also, specialist investors in high-yield and distressed debt invariably spend their time looking at terrible case scenarios. To call them optimists in the context of this piece is a stretch!

Watch my back, bonds

At its best, equity investing relationship is a partnership – all shareholders, sharing in the spoils. The success of multi-billion companies that began trading as tiny acorns shows the riches that can be generated for early investors.

As a bond owner though, there’s almost an adversarial dimension. At best you get what you expected when you bought the bonds. Things can only get worse from there.

On the flip-side, bonds have other attractions.

The most important is, again, that you do know when you buy a bond what return you should make, provided it doesn’t default and it’s held until it’s redeemed.

Equity investors might hope for this and that return, but there’s no guarantee with share prices. Even the dividend can be cut or scrapped.

Another important draw for bondholders is they stand ahead of shareholders in the queue for any cash that comes out of the company – interest payments are made before dividends – and for whatever is going when a company is wound up. Shareholders rarely see any leftovers.2

These important properties of bonds again concern downside protection, though, whereas you own equities for the uncapped upside.

Bonds are for pessimists, and shares are for optimists.

Of course, in investing it’s best to have both optimism and pessimism reflected in your portfolio.

Fair dinkum

We never know what life or the markets will do. We therefore look ahead to all weathers.

The point of bonds in an equity-focused portfolio is to dampen volatility and to shore up returns when things get rough.

Similarly, even the most safety-first, bond-heavy portfolio will improve its expected return with 10-20% in equities. That’s the benefit of diversification.

Also note that while most Monevator readers invest via funds, not in individual bonds and shares – and rightly so – the same principles hold true.

You might object and say you’re not naturally very optimistic but you hold shares because the data says they’ve beaten the other main asset classes over long periods. I agree. But understand there is no guarantee they will do so in the future, especially over just a decade or two. That shares will even go up over time and deliver a positive return is not a given.

In contrast with bonds the expected return can be calculated. It might be a low return and you might not like the look of it, but that’s a different matter!

Shares are an optimistic investment, and bonds the pessimistic backstop.

1. See that post for my flimsy rationale as to why. Unlike my co-blogger I’m an active investor in individual shares, which is something I think most people shouldn’t do. Putting money into mini-bonds is something I think even I shouldn’t really do! [↩]
2. Note for pedants: Yes, I am grossly simplifying what happens when a company is wound up here, the capital structure and so on. That’s for another day! [↩]