3.1.1 Knowing the risks

You 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.

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MARTIN UPTON

Anthony, in your experience, do investors really understand the risks they are taking with their investments?

ANTHONY 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. It 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.

MARTIN 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?

ANTHONY 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. So, 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.

MARTIN 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?

ANTHONY 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.

MARTIN UPTON

So it does come back to the personal investor?

ANTHONY 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.

MARTIN 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.

ANTHONY 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.

MARTIN 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?

ANTHONY 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.

MARTIN 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?

ANTHONY 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. Now 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, independent 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. The 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.

MARTIN UPTON

So by the sounds of it you think the regulator is doing a pretty good job then in terms of regulating fees?

ANTHONY 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.

MARTIN 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?

ANTHONY 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.

MARTIN UPTON

Right.

ANTHONY 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.

MARTIN UPTON

A fund manager that underperforms, particularly year after year after year, should they be repaying their fees to the investor?

ANTHONY 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.

MARTIN UPTON

OK.

ANTHONY 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.

MARTIN 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.

ANTHONY 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.

MARTIN UPTON

Thank you.

ANTHONY NUTT

Thank you.

End transcript

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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. You 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.

Table 3.1 presents a summary of the ‘high-level’ and the ‘underlying’ investment risks that sit underneath these key risks.

These risks are, of course, interrelated. Can you identify some of these interrelationships?