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  • Fortune doesn’t always favour the brave

    High-risk investments should only make up a small part of investors’ portfolios. Here’s why.

    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

    Managing risk is a key foundation to building and maintaining a successful investment portfolio. Weighing up the different risks and rewards should form a big part of your decision-making process.

    You might’ve heard the phrase “high risk, high reward” before? The phrase gets bandied around a lot, but it doesn’t always hold true in the investing world.

    We look at why high-risk investments, like individual shares in smaller companies, should only make up a small part of your portfolio – that’s if they’re something you’re considering at all.

    This article gives you information to help you choose the right level of risk for you. But it’s not personal advice. If you’re not sure what’s right for your circumstances, we have experienced financial advisers who can help.

    How we look at risk

    Risk as a concept has lots of different definitions. But to keep things simple, we can broadly split it up into two main categories:

    Risk of loss – all investments carry a degree of risk. There’s always a chance you could get back less than you invested. We invest with the hope our investments will perform well and grow in value, but there are no guarantees.

    Volatility risk – investments move up and down in value, some more sharply than others. Volatility measures how regularly and abruptly prices swing. If the price stays fairly stable, the investment has low volatility. If the price bounces around a lot, the investment has high volatility. Riskier investments are nearly always more volatile which means they reach new highs and lows very quickly.

    More risk, more return

    In most cases, the more risk you’re prepared to accept, the higher the potential profit. Although of course there are no guarantees.

    The graph below shows how the two of the UK’s major indexes have both grown in size, but at different paces. Companies that make up the FTSE 250 are smaller in size and stature, so they’re riskier and more volatile than their larger counterparts in the FTSE 100. We recently looked at why company size matters when managing risk.

    FTSE 100 vs FTSE 250 (2000-2020)

    Past performance isn’t a guide to future returns. Source: Lipper IM, to 31 December 2020.

    On average, investors that accepted the extra risk and bigger price swings linked with FTSE 250, would’ve been rewarded with higher growth than if they invested in the FTSE 100.

    That’s not to say you’ve got to sit firmly in one camp or the other. It’s important to look at your overall portfolio risk rather than the risk of individual investments.

    Holding a mix of investments across different indexes, geographies, sectors and industries can help build a diversified portfolio with a level of risk tailored to suit you.

    More risk always pays off?

    Not always.

    This graph above is an example of the stock market performing as we’d probably expect it to. It fits the narrative of higher risk, higher return.

    But, stock markets don’t always perform as you’d expect and the relationship between risk and return doesn’t always hold true.

    Higher expected returns are only expected – not guaranteed – and not all risks are rewarded. As investments become more speculative, the likelihood of picking a loser becomes just as great as picking a winner. Share prices for speculative investments can swing wildly too.

    The FTSE AIM index – which is a home for small and medium sized growth companies – has been the worst performing UK index over the past 20 years.

    Performance of the FTSE indexes between 2000-2020

    Past performance isn’t a guide to future returns. Source: Lipper IM, to 31 December 2020.

    Is the extra risk really worth it? Ultimately that’s your call to make.

    We think it’s important for investors to weigh up both the downside risk and upside potential, while making investment decisions through a long-term lens – that’s five years or more.

    What level of risk is right for me?

    Other risk factors

    We’ve covered why the size of a company can make an investment riskier, but there are other factors to consider when managing risk. These include, but are by no means limited to:

    • Company-specific risk – no company is immune to bad news. Changes to management, poor annual results or negative speculation can see share prices decline, even for the biggest and best companies.
    • Interest rate risk – fluctuations to interest rates can impact the prices of fixed-interest investments like bonds. It can also put downward pressure on share prices, especially in growth companies, as their future cash flows are worth less when interest rates rise.
    • Inflation risk – we invest to grow the buying power of our money. If inflation laps the performance of your investments, your money is worth less in real terms. For example, inflation grows at 3% but your investments grow at 2%, your money is now worth 1% less.
    • Currency risk – occurs when you own foreign investments. It’s the risk of losing money because of a weakening currency. For example, sterling becomes less valuable relative to the US dollar, any US investments would then be worth less when converted back sterling.
    • Foreign investment risk – when you hold foreign investments, particularly in less developed nations, there is often more political uncertainty and bigger swings in the state of the economy. This can affect the price and volatility of your overseas investments.

    Think about a core-satellite strategy

    Hand-picking a mix of different investments to match your attitude to risk and goals can be tricky, even for the most seasoned stock pickers.

    While there’s no one-size-fits-all approach, we think a core-satellite strategy is a great one for lots of investors – both novice and experienced.

    The core is your main group of investments – a mix of collective investments, like funds or investment trusts, that match your risk profile. This should be the bulk of your portfolio.

    Your core investments could be surrounded by smaller satellites to help put your personal spin on your portfolio. These could be more collective investments, or individual shares that don’t necessarily match your risk appetite on their own, but fit in with your overall portfolio risk level once added alongside your core investments.

    Ready to build your portfolio?

    Our investment research team have put together some investment ideas to help you get started, but they’re not a personal recommendation to buy.

    Mixed investment funds can be a great way to spread money across lots of shares and bonds – helping achieve greater returns with a relatively-lower level of risk.

    For investors prepared to accept more risk, small and mid-sized companies funds can offer you an adventurous, but higher risk, way to grow your wealth.

    Investing in funds isn’t right for everyone. Before investing it’s important to check the fund’s objectives align with your own, understand the fund’s specific risks and if there’s a gap in your portfolio for that type of investment.

    Remember, funds go down as well as up in value, so you could still get back less than you put in.

    Investment ideas

    AXA WF Framlington UK

    • Invests in UK companies across a range of sizes.
    • Focuses on high-quality companies.
    • Invests in higher-risk small and medium-sized companies.

    Find out more

    Find out more

    Baillie Gifford Managed

    • Can make a great core for most growth-focused portfolios.
    • Investments from around the world.
    • Could boost the growth of a more defensive portfolio.

    Find out more

    Find out more

    AXA WF Framlington UK

    This fund invests in UK companies across a range of sizes. The fund manager looks to pick companies he thinks have lots of potential to grow over the long term – though of course there are no guarantees.

    The fund invests more in higher-risk small and medium-sized companies than some other funds. When building a well-rounded portfolio for long-term growth, think about balancing with funds focused on more established companies.

    The manager's focus on high-quality companies means it could also sit well alongside a fund that invests in companies believed to be overlooked and undervalued. His focus on broader themes and the way they impact individual companies makes it quite different to other funds.

    This is an offshore fund, so investors aren’t normally entitled to compensation through the Financial Services Compensation Scheme.

    More about this fund, including charges and how to deal

    AXA WF Framlington UK Key Investor Information

    Baillie Gifford Managed

    We think this fund can make a great core for most growth-focused portfolios. It invests in companies across the world and has a huge amount of diversification in one investment. It also invests in some bonds as well as cash, which could reduce volatility when markets get tougher.

    Shares tend to make up more of the fund than others in the same sector, so it’s more adventurous than lots of other mixed-asset funds.

    When investing in companies, the managers look for businesses they think have lots of growth potential and take a truly long-term view.

    It could boost the growth of a more defensive portfolio with a focus on bonds or add a little stability to a portfolio focused on shares. The fund can invest in derivatives and emerging markets, which can increase risk.

    The fund currently has a holding in Hargreaves Lansdown PLC.

    More about this fund, including charges and how to deal

    Baillie Gifford Managed Key Investor Information

    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

    Learn more about investing

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    Category: Investing essentials

    Diversification: what you need to know

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    Risk: what you need to know

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    Investing behaviours: what you need to know