Choosing a company
Risk versus reward
The central principle of risk is that the higher the risk, the higher the potential rewards.
A second principle is that there’s always a degree of risk in owning investments. Because investment companies are stock market investments they carry a certain amount of risk. In extreme circumstances you could even lose all your money.
It’s not easy to make a precise assessment of risk when it comes to the performance of markets, sectors and companies. Markets are inherently unpredictable. Sectors that look unhealthy may start performing strongly and steadily, and companies that look dominant may suddenly reveal hidden weaknesses. It is important with any investment not to be a forced seller: allow yourself to choose a time to sell that is advantageous to you. It may be more difficult for an investor to realise his or her investment on the AIM market than to realise an investment in a company whose shares or other securities are quoted on the Official UKLA List.
It’s also not possible to draw up hard and fast rules about the risk levels of a particular kind of investment company. No two companies are identical. For example if you are considering investing in a split capital investment company, you will need to look at the risk associated with a particular share class; the structure of the company and the company’s overall risk.
Roughly speaking, the level of risk you might be prepared to accept depends on how long you can tie up the money. If you’ve got time on your side, you can view your investments over the longer term and you may be able to take relatively more risk in exchange for the possibility of higher returns. Investment companies are primarily intended as long-term investments. As with all equity investments, it is important not to be a forced seller: allow yourself to choose a time to sell that is advantageous to you. Investment companies offer a range of exposure to risk through portfolio and market diversification, use of gearing and capital structure.
General information about financial services is available from the Financial Services Authority (FSA). The FSA is an independent watchdog set up by the government to regulate financial services and protect your rights. It provides free and independent information about financial matters on its website and includes a section on risk.
Some key risk features associated with investing in investment companies shares are discussed below.
Gearing
As explained in What are investment companies, investment companies are allowed to borrow money to buy more assets. The profit they make on the extra assets is intended to cover the interest on the loan, and leave an additional profit for ordinary shareholders.
But, the more an investment company borrows, the more risky it is. What if the extra assets perform badly?
So, broadly, the higher the gearing, the higher the risk.
Volatility
The stock market price of shares can go up and down. For example, when a company is doing well, its share price may go up and the value of your investment rises but if the company is not doing so well, its share price can go down and the value of your investment then falls. Share values are also affected by the overall level of confidence in the economy at home and the international economic climate. The more the value of the share price moves both up and down over a period of time the more volatile it is regarded as being.
There are several ways to measure volatility, but the most common method used is the standard deviation. Standard deviation measures the extent to which a value, such as the share price, has varied around its average level during a past period.
Volatility aims to provide a measure of historic fluctuations and can be used as a method of assessing the level of uncertainty that may surround the expectations, understanding and value of an investment - in other words, how risky it is. This information can then be used by an investor to ascertain the degree of uncertainty that may surround a particular investment. For example, if two shares deliver the same performance at the end of a measurement period, and the price of share A moves steadily over the period and share B moves up and down more dramatically over the same period, share B, with the higher volatility, has shown a higher level of uncertainty than share A.
It should be noted that a measure of standard deviation is accurate only within the parameters of each calculation (e.g. the specific time period: 3 months, 3 years etc.). There is great scope for calculating behaviour over different time periods, and thereby assessing different historic volatilities.
Although often used as part of an assessment of risk, volatility must be considered in conjunction with other factors and is not an indication how well your investment will perform in the future.
Discounts and premiums
As explained in the What are investment companies, more often than not, investment company shares tend to trade at a "discount", i.e., where the share price is lower than the value of the underlying assets, expressed as the net asset value (NAV) per share.
Investors buying shares at a discount are paying less than the underlying assets are worth. Investors buying at a premium pay more than the value of the assets. Take care not to assume that the former is automatically a good thing and the latter bad. It is the prospects of the underlying assets that will, over time, drive the share price. Whilst discounts can be a useful market indicator, discounts can widen just as easily as they can narrow. The discount/premium is just one factor amongst many and should never be the sole reason for a purchase or sale. Ultimately, the share price could at any stage be lower than the price at which you bought the shares.
If the discount narrows during the period of your investment, it provides a proportionately better return on the share price than on the underlying assets. A widening of the discount does not necessarily indicate a loss although it will reduce the gain you could potentially have received. Any investment in shares should be for the long term and as such any movements in the discount should make little difference to the end result.
When considering buying shares trading at a premium you will have to decide whether there is a good reason for paying more than the value of the underlying assets. If you are unsure about whether to buy, you should take advice from an independent financial adviser familiar with investment trusts. There is a risk that, if you buy shares at a premium, when you wish to sell the shares the premium has narrowed or even moved to a discount.
You should also bear in mind that published share prices can be the ‘mid-market’ price, the selling price (bid) or the buying price (offer). The mid-market is the mid price between the selling and buying prices and as such takes no account of dealing costs. Discounts and premiums are usually calculated using the mid-market price and depending on the spread between the offer and bid price that price at which you are able to deal could ultimately be significantly different to the published price and therefore discount or premium.
Past performance
