For a fundamentally simple concept – albeit one that can be expressed and managed in bewilderingly complex ways - this is poorly understood even, it seems, among finance professionals. An excellent study entitled the Folklore of Finance, published at the end of last year by US financial giant State Street, revealed that many institutional investors appeared unable to distinguish between luck and skill in generating returns. They put success down to their own analytical ability, but often view failure as the fault of the market. In reality, both gains and losses are determined by the risks inherent in their exposures.
Risk appears to equally baffle many of of the nearly 3,000 retail investors State Street also surveyed, who knew that they had to invest in equities to achieve the portfolio growth required to fund retirement, but remained heavily allocated to cash. Presumably they overestimate the risks of holding equities and underestimate the risks that inflation will erode the value of their cash or that they will not meet their retirement savings goal – if, indeed, they actually have one - and suffer a rather miserly dotage.
The low interest rate environment and subsequent hunt for yield has also led investors to take some decisions which underplay the risks they are taking. One of these is, blinded by high headline yields, to invest heavily in minibonds. These are unregulated debt products usually issued by very small companies which should be clearly distinguished from the retail bonds traded on the London Stock Exchange. As our companies editor Stephen Wilmot notes on page 51, the coupons offered by these Orb listed bonds are very generous compared to the low risks that accompany them. In comparison, the marginally higher coupons on minibonds barely make up for the higher risks of default they exhibit – just as one minibond issue, Secured Energy Bonds, did in January, as we had earlier speculated it might.
One risk investors are currently concerned about is political risk in the form of the imminent General Election, and in response to several readers’ requests we have assessed what the various outcomes could mean for UK plc in this issue. But our research suggests we need not get too worked up by election fever. While there are certainly real risks, most of these are sector or company specific, well flagged, and manageable if you happen to have exposure to them. Arguably the political risks we need be more concerned about are those further afield with much longer-term implications.
