What is risk?
Risk is usually defined as the volatility an investment is exposed to. Volatility is a measure of the range of returns on an investment over a given period, compared to the mean. The higher the volatility, the riskier the investment.
No one can foresee the future, meaning the risk investments will be exposed to in months or years to come is inherently uncertain. However, the asset management industry can assess the prior performance of an asset and how market conditions might develop to form an outlook on how much risk the asset is likely to be exposed to in the future.
Inflation and returns
Inflation reduces the purchasing power of money. For example, a pint of milk today costs almost double what it did in 1990.
When calculating your return on an investment, inflation needs to be considered. A nominal return is your superficial return on an investment, whereas real returns are adjusted for inflation.
How are returns on bonds calculated?
Credit rating agencies rate bonds by the amount of risk they’re exposed to. If a bond is exposed to more risk – for example, if the business that has issued it is in danger of going bankrupt, meaning the bondholder may not get their money back – it will receive a lower credit rating.
Credit ratings span AAA to D. Any bond below a CCC credit rating is consider a junk, or ‘high yield’ bond. As their name suggests, high yield bonds pay high rates of interest to bondholders, but they are riskier than bonds with better credit ratings.
In contrast, bonds with strong credit ratings (so-called ‘investment-grade’ bonds) are less risky but pay lower yields to investors. A classic example of a very low-risk investment-grade bond is a US Treasury bond. The investor will only not get their money back if the US government is unable to pay its debts, the risk of which is near zero.
There is no ‘right’ approach to constructing an investment portfolio. A range of approaches can be appropriate, based on investment goals, time horizon, risk tolerance and other factors.
For an asset management firm, deciding what levels of exposure to different asset classes a fund should have – meaning the proportions of the fund that will be made up of different asset classes – is a real skill. A firm considers its clients’ characteristics, goals and risk tolerance, and chooses the fund’s allocations to different asset classes in accordance with this.
However, as markets are inherently unpredictable, it’s very difficult to make investment decisions that result in exactly the desired amounts of risk, return etc. This is where the expertise of fund managers is key.