Business

Peter McGahan: Assessing your money’s potential for loss

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LAST week we covered concentration risk with your investments. To summarise, it’s when you spread your investments too far and find yourself buying the same shares in different funds. That’s not diversification.

I’ve had a couple of questions around that which can be covered in one sentence. No, pension providers and investment funds do not automatically check for this, and don’t assume that financial advisers do too.

When you have concentration risk in a fund and markets and that sector falls, it falls exponentially. That isn’t the stabiliser that you hoped for within your funds.

There are methods of assessing concentration risk and make sure you ask about that on your next review. However, there are other key risks in a fund that you should also look out for, or ask about. This is a bit of science, but, bear with me. All of your pensions and ISAs/investments are affected by the items below. You want the best returns for your security later so they all matter.

Standard deviation calculates how much a fund’s return deviates away from its average return. It’s a good way of seeing what risk is being taken in a fund especially when compared to peers. So, if we put all the funds in the pot and one has a large deviation away from its average and others don’t, you know something strange is happening inside that fund to ask questions. All you do need to know is that any swing downward will be greater.

It is important that this risk is calculated over a five-year period. The reason? If a market is moving upward with momentum, it often doesn’t deviate much. If we move to a five-year period, you are more likely to bump into a downturn which will highlight the aforementioned risk properly.

Another measure is maximum drawdown. This assesses the peak to drop fall in a fund over a given period. Once again, this, when compared to other funds in its sector will show other potential risks like borrowing, over exposure to a sector, concentration risk and low diversification, or indeed just poor management.

Maximum loss is another key assessment which illustrates the longest running loss without making a gain. This assessment often shows a lack of active management within the investment.

Before I bore the head off you anymore, your financial adviser should be doing all of this, but these are really important measurements that are more often than not completely overlooked.

Another key risk is downside risk. It’s a more complicated assessment but it really assesses the potential for a fund to suffer declines in negative market conditions, and you could say, assesses the potential loss of an investment.

To give you an example of that, I visited a fund group to assess their fund and ask them key qualitative questions around the numbers we had for them.

When I specifically asked about downside risk I told them that when I weighted our assessment against this risk alone they moved from top in the sector to close to the very bottom and why would that be. As you see from above, downside risk is very different from standard deviation yet they used standard deviation as a demonstration of its risk, and I should ignore downside risk. I reminded them that they showed two very different risks.

They didn’t understand that. I asked it to five key staff present. They didn’t understand that still. Furthermore, I pointed out they had used three-year standard deviation which was of course useless.

In reality, it was the fact they were using three-year standard deviation to make their assessments that they ended up with the large downside risk, as they were buying their funds based on assets assessed in an upward rising market, over a small period – three years. When it goes pear-shaped, boy does it.

Finally, we like to compare information ratio. Trust me on this, it’s one of the more complex measurements and you will be glad I’ve run out of space at the end of this column.

My apologies for a more science-based column than my normal style, but it’s complex and also important to protect your money.

Peter McGahan is chief executive of independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. Would you like a complimentary review of your investments? If so call Darren McKeever on 028 6863 2692, email info@wwfp.net or visit wwfp.net/