This article Appeared in the August 2007 edition of EN Magazine

Market volatility: manage your risk

Jeremy Gibbs Director, G&E Wealth Mangement Ltd.

Corrections, bubbles, spikes, froth, peaks, troughs, bulls and bears. The last few turbulent weeks on world stock markets always leads to a crescendo of phrases that ultimately can confuse, baffle or of course dent investor confidence. So how do you invest so that you can sleep soundly at night? You manage your risk exposure to a level you are comfortable with and that is done by diversification. A well-diversified portfolio reduces the risk of loss and volatility.

Diversification means spreading your investment across different types of funds or securities in order to reduce risk. Historical analysis has shown that diversification across asset classes consistently increases the chance that as one investment is falling in value another may be rising. Furthermore asset allocation, on average, accounted for 91.5% of the variation of portfolio returns over time. This is much more than other variables such as stock selection or market timing. ( Source: Brinson, Singer, Beebower 1991).

When Greeks threw dice in ancient times, they believed the outcome was fixed by the gods rather than ruled by the laws of probability. The concept of risk as uncertainty did not yet exist.

Probability theory has provided a methodology to make rational decisions about the future. By quantifying risk, it is possible to make rational choices about which risks are worth taking, instead of simply monitoring returns and neglecting the level of risk that is taken to generate them.

Risk is the likelihood of a particular outcome multiplied by the impact it has on you.

• High probability but low impact
  The chances of it raining in the next few days maybe high, but the impact is relatively small.

• Low probability but high impact
  The chances of a large meteor hitting the earth may occur only in exceptional circumstances, maybe once in 200 million years, but the impact would be catastrophic.

By being able to fully understand and analyse risk as part of your investment decision-making process, you are able to manage your assets in a way that can optimise your returns. This is known as ‘asset allocation’.

Diversification is the key element of asset allocation. Research has shown that asset allocation has the major impact on the variability of your likely returns, i.e. how much they might deviate from what you expect. It is possible to increase your expected return while maintaining the same risk level, or keep the same expected return while reducing your risk, by using a disciplined asset allocation process.

It should be borne in mind however, that Investments can rise and fall in line with market conditions and you may not get back as much as you invested. Similarly past performance cannot necessarily be taken as a guide to future performance.

Asset allocation dictates how your investment should be split among the major asset classes (equities, bonds, property and cash), and on a geographic basis ( UK, Emerging Markets, Far East, North America, etc.), so as to match your appetite for risk.

A good quality financial adviser will help you understand your attitude to investment risk and design the asset allocation to match, based upon your own particular circumstances and objectives. The end result is less volatility and fewer sleepless nights.

Jeremy Gibbs – G&E Wealth Management Limited based in York and Leeds.

G&E Wealth Management are authorised and regulated by the Financial Services Authority.