Understand investment risk attaching to funds

Now we can consider different types of funds, and the investment risks that attach to them in the context of three broad categories of risk. The focus is our experience with these funds over the last 10 years - you should also consider the longer historical picture in "Inform yourself about investment risk".

Please remember that past performance is not a guide to future performance. But history is useful in enabling you to explore what sorts of investments suit your circumstances and objectives.

LOWER RISK
You are prepared to accept some capital volatility for the potential of a better return than on deposit, but do not want the day to day risk of a stockmarket investment. This lower risk sector would include corporate bond funds, international bonds, commercial property funds and also protected funds.

The reward:
Over the last 10 years, the total return from a good mainstream corporate bond fund was 86% (net income re-invested), whereas on deposit it was 64%. Over longer periods our expectation is simply for a margin over deposit returns, and certainly nothing like stockmarket returns.

The risk:
Looking at a typical good lower yielding corporate bond fund, based on the last three years, our statistical analysis suggests that in most months you should not see a fall in the capital value exceeding 1.6%*.

Looking back a little beyond 10 years, the worst period was 1994/5. A typical lower yielding bond fund would have lost about 9% in 1994/5, and if you had been drawing income the fall in the capital value would have been more like 15%.

As a guide, the higher the yield on the bond fund, the greater the potential downside.

MEDIUM RISK
This is for those comfortable with stockmarket risk, meaning that you’ve probably lived through periods of extreme volatility before, and are comfortable taking a long view (at least 5 years). This would cover mainstream UK and European funds.

The reward:
Over the last 10 years, the total return from a typical, good, UK stockmarket fund (in this case an equity income fund) was 110% (net dividends re-invested), or 89% from a good fund in the UK All Company sector. In contrast, the deposit return was 64%, and the stockmarket index went up 48%.

The risk:
Looking at a good fund in the UK All Company sector over the last three years, the statistical analysis suggests that in most months you should not experience a fall in the capital exceeding 6%*.

Looking back over 10 years, we have still not recovered the peaks of 1999/2000. The falls began in early 2000 (down 43% at worst on the FTSE All-Share) and, despite a strong recovery through to 2007, the index is still more than 20% below the all time high.

A typical good UK stockmarket fund would have lost a bit more than 30% in the period 2000-2003 though many were at worst down in excess of 40%. Prior to this period, the steepest loss for our “typical good” fund was 14% in 1994, and it took 18 months to recover.

HIGH RISK
We suggest this means that as well as your being attracted to some years of 100% growth (such as with technology in 1999), you must also accept occasional years of 50% losses, and take a 10 year view, at least. This includes tech, Asia/Japan, emerging markets and smaller companies.

Our experience is that high risk funds often do not provide the consistent year to year performance of something like a good mainstream UK stockmarket fund. Not only will you see the value 100% up and 50% down over relatively short periods, but for long periods (years) you may experience lacklustre performance, until it explodes upwards.

The reward:
Occasional years of 100-200% returns.

The risk:
In the higher risk area we can consider a number of sectors to illustrate the risks. Looking at a typical emerging markets fund, based on the last three years, the statistical analysis suggests that in most months you should not see a fall exceeding 10%*.

Over the last 10 years the worst period for a typical Japanese fund was the 44% loss to August 1999. And 80%-plus losses have been experienced by tech funds.

* see FAQs for more on “monthly risk”

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