Recently I revisited the snapshots of UK equity valuation that Investors Chronicle first examined in February 2014. Based on ratios that have historically been correlated with future annualised returns, the FTSE 100 and FTSE All-Share were not especially cheap or expensive. So, while it was an interesting exercise, the net result was more questions than answers: if the market is overall fairly priced, which sectors offer best value? How do equity prices in the UK compare internationally or with different asset classes? These are questions to return to in future but, as the main conclusion of the overview was that it is worth staying invested in UK shares, the first considerations have to be how to quantify the risk of doing so and how can this best be managed as part of a diversified portfolio strategy?
If you have a goal - typically required real total return within a specified timeframe - then as a rational investor you want to take the least risk achieving it. While UK shares may not yet be overpriced, they remain a volatile asset class that could fall sharply in value following a shock to the market. If such an event were to occur (and events in Europe or the Chinese sell-off could provide the detonator) and there was a long period until prices recovered, buying in at today's theoretically fair value levels would still mean getting caught out at the top with all the distress that entails. While this possibility cannot be eliminated, investors can mitigate the impact to their objectives by understanding how each of their holdings exposes them to potential losses.
Understanding risk models