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Skip to 0 minutes and 0 secondsMARTIN UPTON: Anthony, in your experience, do investors really understand their risks they are taking with there investments?

Skip to 0 minutes and 5 secondsANTHONY NUTT (Retired investment director and fund manager): No I don't think they do Martin, but I wouldn't be too alarmed about that. First of all I would try and define what we mean by risk. The word itself is quite concerning for investors, but if you try and understand what your aims and objectives are then you can try and understand the consequences or the likelihood of not achieving those aims and objectives. And that I what I think as an investor you should be thinking about in terms of risk. So less about the untoward fear of investing in something which might go horrible wrong and much more about predictability.

Skip to 0 minutes and 52 secondsIt really is an important point to understand, what you mean by risk, because risk is almost the very parameters by which you will invest; invest successfully or unsuccessfully, if you go outside those risk parameters that you have set for yourself.

Skip to 1 minute and 9 secondsMARTIN UPTON: By risk when it comes to investments, we look at capital risk, the risk that the value of your investment goes down, we look at income risk, that the income from your investments isn't as high as you would want. There are other risks as well, like foreign currency risks, take the decision to place money in foreign currency denominated investments. When it comes to the investor community though, which are the risks that people commonly misunderstand or perhaps don't think about at all?

Skip to 1 minute and 41 secondsANTHONY NUTT: Well they're all risks that one should consider but let me say to you if you are an investor in fixed interest and equity markets; they are that the people you provide capital to will be thinking about very hard indeed. They will be hedging currency; there will be many large companies have enormous risk departments, just dealing with all these issues. You know for me I think as the private investor you should be more concerned about you yourself misunderstanding risk, and making investments that are less about discernible, predictable, reliable returns and more about speculating.

Skip to 2 minutes and 27 secondsSo, you may invest in the equity market for instance, with the intention of making a more significant return that is really reliable, that is really realistic. And that I think is where we go wrong in misunderstanding risk.

Skip to 2 minutes and 48 secondsMARTIN UPTON: Whose reasonability is it to get the personal investor up the learning curve when it comes to understanding risk? Is it down to the personal investor, should it be financial firms and advisors who they can approach about investments or is it the duty of the regulator to protect the investor from an adverse risk appetite?

Skip to 3 minutes and 9 secondsANTHONY NUTT: Well that's a really good question because I feel at the moment that the onus is put by the government, by the regulator, on the advisor, if ones using an advisor, to quantify the risk. And it has become a box ticking exercise, which is really very inadequate. So your advisor will ask you are you a low risk investor or a medium risk investor or a high risk investor? And he will tick the box. But you know what he's doing Martin he's considering his business risk, and less of your investment risk. So you have to decide, you have to do your utmost I would argue to try and understand the risks you are undertaking.

Skip to 3 minutes and 55 secondsMARTIN UPTON: So it does come back to the personal investor?

Skip to 3 minutes and 59 secondsANTHONY NUTT: Ultimately, I would argue that if you, me, everyone, the government, can educate ourselves in trying to understand what it is we want from our investments, less about speculation, less about gambling in the stock market, more about discernable returns, more about good corporate governance, reducing risk and things going wrong at board level for instance, and therefore our earnings. So I think we all have a role to play here and at the moment really the emphasis is less...is left with the advisor to quantify the risk having asked some terribly basic questions to an individual what their risk appetite is. And they may not even know they may not, as you alluded to, understand what their risk requirements are.

Skip to 4 minutes and 55 secondsMARTIN UPTON: So if I'm a personal investor and I say yes I want medium risk it's really down to me to make an effort to understand what medium risk really means and what I'm exposing myself to.

Skip to 5 minutes and 6 secondsANTHONY NUTT: It is, and more so to make sure that your advisor, if you use an advisor, understands what you mean by medium risk because he then may be able to help you out in identifying whether you are genuinely a medium risk investor, because you might actually be a low risk investor.

Skip to 5 minutes and 25 secondsMARTIN UPTON: Anthony one big decision that investors have to make is "do I take financial advice before making my investments or do I, so to speak, fly solo and make my own decisions?" What's your advice on this?

Skip to 5 minutes and 38 secondsANTHONY NUTT: Well my advice would be that depends on how sophisticated you are on understanding financial matters. If you are coming to the investment arena for the very first time and know little about financial matters then I would seek advice. And sadly the quality of advice you are going to get depends on how much you are going to pay for it. If you are an accountant yourself, if you understand financial matters on a much more significant understanding of these financial matters then by all means fly solo, by all means go it alone, do your own homework, understand the risks, look at your aims and objectives.

Skip to 6 minutes and 22 secondsMARTIN UPTON: You talked about fees there and the investor having to pay for advice and you know there has been a lot of debate, a lot of discussion about the fees that are paid to fund managers. What are your views are those fees generally in order or are they excessive?

Skip to 6 minutes and 40 secondsANTHONY NUTT: Well I think Martin it really does depend upon the product that you are choosing to invest in. There is no doubt in my mind that some products are heavily overpriced, they are weighted too much in terms of the fee towards the underlying fund manager. We think of performance fees within the hedge fund community for instance. And at the other end of the spectrum, maybe index tracking, there are products that are very lowly priced and can retain the same sort of returns as an index by their very nature. So it does vary enormously and it is important to understand what level of fee you'll be paying.

Skip to 7 minutes and 25 secondsNow I do think the regulator, the government and the regulator has had a very useful role to play in this in recent years in forcing the investment community, the investment professionals, fund managers, independant financial advisors to make more explicit what their fee charges are. So you can make a much more educated guess now than was the case in the past in terms of what your fee levels are likely to be. I should say at this point that the initiatives we've seen from government in the past to make very simple investment products very lowly priced hasn't really worked.

Skip to 8 minutes and 8 secondsThe investment community hasn't been very keen on taking up some of those very lowly priced products because it can be quite an expensive process to provide a product to the retail community in particular at a very, very low price.

Skip to 8 minutes and 28 secondsMARTIN UPTON: So by the sounds of it you think the regulator is doing a pretty good job then in terms of regulating fees?

Skip to 8 minutes and 35 secondsANTHONY NUTT: He's doing a much better job I would say than has been the case in the past. The city understands, the investment community now generally understands what's required of them in terms of an appropriate level of fee charging.

Skip to 8 minutes and 51 secondsMARTIN UPTON: But it's also important that the personal investor doesn't turn a blind eye to that percentage which they are paying in terms of fees. It's typically a small percentage and people are maybe inclined to just ignore it and not think about how it impacts upon their investment return over the longer term. Is that a fair observation?

Skip to 9 minutes and 12 secondsANTHONY NUTT: You know my observation over the years would be that actually the retail investor does look at the level of fees he's paying.

Skip to 9 minutes and 19 secondsMARTIN UPTON: Right.

Skip to 9 minutes and 20 secondsANTHONY NUTT: He looks at what the return has been and he does make a judgement about the level of fees that he has been paying. And too often I think the level of fees have discouraged him from investing perhaps when he should have been investing. So I do think people do look at fee charges, they are concerned, they have been concerned about fee charges and the press has done a relatively good job of taking up some of the more extreme examples of too high fees.

Skip to 9 minutes and 54 secondsMARTIN UPTON: A fund manager that underperforms, particularly year after year after year, should they be repaying their fees to the investor?

Skip to 10 minutes and 4 secondsANTHONY NUTT: Well I don't know how a fund manager would repay those fees quite frankly if the fund has underperformed significantly investors tend to take their money out over a prolonged period of time. And these funds dwindle and his business risk rises and he goes out of business in theory.

Skip to 10 minutes and 23 secondsMARTIN UPTON: OK

Skip to 10 minutes and 24 secondsANTHONY NUTT: But I don't think we'll ever see underperformers reimbursing fees because fees go to provide a lot more than simply buying and selling investments. There's a good deal of admin that takes place behind that.

Skip to 10 minutes and 37 secondsMARTIN UPTON: Yeah I mean a certain amount of the fees which you do pay go towards such things as research undertaken by the financial firms.

Skip to 10 minutes and 45 secondsANTHONY NUTT: Yes I think that's true there is a good deal depending on the size of the firm there is a good deal of resource applied to researching companies and the underlying investments that they offer the retail investor.

Skip to 10 minutes and 57 secondsMARTIN UPTON: Thank you.

Skip to 10 minutes and 58 secondsANTHONY NUTT: Thank you.

Knowing the risks

We now turn to investment risks. Let’s start by hearing Anthony Nutt’s views on investment planning and managing the risks involved. Investment risk is the likelihood that the actual return from an investment will not turn out as expected. There are two dimensions to risk: amount and timing.

In summary, risk is the chance that the actual return from an investment will:

  • be more or less than expected. This is known as capital risk and, if part or all of the return is in the form of income, income risk.
  • not be available when expected. This is an aspect of liquidity risk.

Capital risk, income risk and liquidity risk can therefore be viewed as the key ‘high-level’ risks affecting investments.

Note the assumption that risk is symmetrical: the probability of a gain is equal to the probability of a loss. Although investors typically want to avoid the downside risks of a lower return, they do want exposure to the chance (risk) of a higher return. We will follow the normal convention of describing different types of risk in terms of the bad outcomes that may result, but you should bear in mind that the risk–return trade-off means that the reward for running the risk of bad outcomes is the chance of superior returns.

Set out below is a summary of the ‘high-level’ and the ‘underlying’ investment risks that sit underneath these key risks.

  High-Level investment risks
Capital risk The risk of loss of some or all of the original capital invested and returns made to date
Income risk The risk that the income earned from an investment is lower than expected by the investor when the investment was made
Currency risk Where an investment is denominated in a foreign currency, unexpected changes in the exchange rate may cause the sterling (or other home currency) value of the holding to be less than expected. Similarly, this can be a risk when a person borrows in one currency to purchase an investment or other asset in another currency (for example, borrowing in euros to buy a home in the UK)
Liquidity risk The risk of being unable to sell or cash in an investment or being only able to cash it in at a prohibitively low price
  Underlying investment risks
Counterparty risk The risk that an entity responsible for payments to an investor fails to meet its contractual obligations – for example by failing to pay interest when it is due
Default risk The risk that the entity invested in becomes insolvent and fails to return the sum invested
Inflation risk The risk that the return from an investment is reduced in real terms due to an unexpected rise in prices
Interest-rate risk The risk of making an investment choice on a view of future interest rate movements that turns out to be incorrect
Shortfall risk The risk that a pre-defined target return from an investment fails to be met

These risks are, of course, inter-related. Can you identify some of these inter-relationships?

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Finance Fundamentals: Investment Theory and Practice

The Open University