Learn About Investing

Learn About Investing

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Asset class risk

This is an article about asset class risk and how it relates to investing in general, not Orbis Access in particular.

Asset class risk

Bigger climbs, harder falls

What’s risky and what isn’t?

You face investment risk with each individual asset you own, but there are also risks related to asset classes as a whole. In other words, these ‘classes’ – like shares, bonds, property and cash – have their own risk profiles.

The general view is that among the main asset classes shares are at the higher end of the scale of risk, cash at the lower end (see chart). While this is broadly true, it hides a lot.  

Asset Class Risk Graph

To many, financial risk is the danger of losing money – or ‘capital loss’ in the jargon. However, in the world of investing risk is closely associated with volatility. In the past, shares have been more volatile than bonds and cash; in other words, they have been subject to bigger swings in price. This may not be a problem if you are investing for the long term and only intend to cash out in a decade or two, but it can be a real issue over shorter investment periods.

You don’t want to find yourself having to sell shares just after the market suffers an abrupt downturn. It may not be any help to you right then – if you need the money right away – that prices could swing back up in three years.

The trade-off for share owners historically has been that they have enjoyed higher returns than bonds and cash over the long run.

What this chart is not telling you is that there are big variations in risk within each asset class. 

Some shares are much riskier than others. The level of risk depends on a number of factors, not least how much you paid for the shares in the first place. Other considerations include the qualities of the company itself and the environment it trades in. For example, owning shares in a retailer like Marks & Spencer – a FTSE 100 stalwart worth billions and in business over a hundred years – could be seen as less risky as owning shares in a retail start-up (offering shares on London’s Alternative Investment Market, which lists ‘small’ companies).

It’s the same story with bonds. It is widely believed that US Treasury bonds are a pretty safe haven. The US government has never yet defaulted on its debt, so people reckon that if the US government says it’s going to pay you back in future, then it probably will. The result is that their bonds yield little. The assumption is: safe but dull.

At the other end of the spectrum, one could buy a bond from a company that looks like it’s in trouble. It may go out of business before the bond ‘matures’ and you never get your money back. This is clearly highly risky, but the returns would be much higher provided the company survives.

Between these points, you can find a broad range of assets with varying risk – including riskier government debt and ‘investment grade’ corporate bonds issued by some of the biggest (and most stable) companies in the world.

The upshot is that a corporate bond could be riskier than shares in a large company.  Even cash savings accounts bearing unusually high rates of interest may be doing so because there is additional risk lurking. The infamous collapse of Icesave during the crash of 2008 shook the perceived wisdom that bank accounts are always ‘safe’.

What it means for you

To counter asset class risk, investors tend to hold a mix of different asset types with a range of risk profiles. The appropriate proportions of each depend on a number of factors – such as the intended timespan of the investment, the amount invested, personal appetite for risk and so forth.

Unhelpfully, there’s no right or wrong when it comes to selecting the best mix. It’s only with hindsight that one can ever know for sure what the best option would have been.

If you want your money back within three years, or are unwilling or unable to accept significant downward swings in value (at any point), a focus on asset classes with lower risk profiles – cash in particular – is generally recommended. But if you’re prepared to invest long term, assets like property and shares deserve a closer look.