When you invest in funds you take various kinds of risk. One risk may be that the value of your savings fluctuates very sharply. Another is that you lose some of the money you are investing, and a third that you obtain a lower than average return for the market in which you are investing.
Think about risk when making your choices
The different concepts of risk are to some extent linked. For example, it is quite easy to understand that if the value of your savings fluctuates sharply up and down there is a large risk that they will sometimes be worth less than when you started saving. It is important to know something about the risks of different savings options before deciding how to save. It is possible to reduce the risks in different ways, but you cannot entirely mitigate all risks if you want the possibility of achieving a higher return than the interest rate on a fixed-income security issued by the government.
You may know that there is a relationship between risk and return, which means that in order to have a chance at really high returns you must also be willing to take big risks. But it is important to remember that this does not mean you will automatically obtain a high return just by taking sufficient risk. There are many high-risk investments with no return at all and others that offer a very poor yield. This is precisely why they are high-risk investments.
There are various ways to measure risk, but common to all is that they base their calculations on historical risk. Making accurate predictions of future risk is impossible, for the simple reason that no one knows what will happen in the future.
The most common way to measure risk is to calculate how strongly the returns from an investment vary between periods. The risk obtained in this way is usually called the total risk. A statistical measure called standard deviation is used for this calculation. Basically this means that you calculate how much the return varies on average during different periods from the mean for all time periods. It may sound complicated, but on the other hand it is not particularly important to understand in detail how the calculations are done; it is important that you understand how to interpret data on total risk in different investments.
If the return varies substantially from period to period we say that the total risk is high, while a low total risk means small variations. Another way of expressing the same thing is that if the value varies widely between different periods, it is difficult to know in advance what the savings will be worth at a given time in the future. If the fluctuations are large, your savings could be worth much more than today, but it is also not possible to rule out a decrease in value. In this way, therefore, the concept of total risk is also connected with what most fund investors perceive as risk, that is to say the risk of losing some of their money.
The total risk is therefore calculated from the size of the historical fluctuations, and it is hoped that this will give an idea of how risk will be in the future. But there is no guarantee that this will actually be the case. To include as many observations as possible, while avoiding the problems of holidays, and in accordance with new European regulations, we use weekly returns in our estimates of the total risk for a specific time period, such as the latest two years.
The ranking does not change
The total risk measured using standard deviation can vary from period to period. In recent years, for example, the volatility of the stock markets has been much larger than in the mid-1990s. But even though the risk changes between periods, the ranking among different types of investment does not usually change. Yields on fixed-income funds vary less than on equity funds. Funds that invest in many different stocks in various industries across the globe vary less up and down than funds that invest only in a single country. Funds that invest in equities in emerging markets, such as Asia and Eastern Europe, vary much more up and down than, say, funds that invest in Western Europe or the United States.
As an investor in funds, you can guard against the total risk by spreading your money between funds with different orientations and by always making sure you have a portion of your savings in some form of investment that pays interest, such as a fixed-income fund. The money you have in a fixed-income fund is only marginally affected by what happens in the stock markets and provides a much more stable return. The major advantage of equity investments, however, is that long-term yields should be significantly higher than from savings with interest. As fund managers we constantly monitor the level of risk in our funds. If we are to accept higher risk, we must also be reasonably confident that we will get compensated for this risk through higher returns.
So far, we have described the total risk in different investments. There is another kind of risk for fund investors and fund managers, namely that of the fund performing very differently from the average (index) for the market in which it invests.
To measure this risk we compare the performance of the fund with a benchmark index. If there is substantial correlation between a fund and its benchmark, the fund will perform largely as index. If there is little correlation the fund will likely perform differently than the index, either better or worse. The safest way for a fund to perform like an index is for the fund to be constructed with the same composition as the index. This is not how we work at Catella Fonder. We are active managers and are confident that by allowing the composition of the fund to deviate from the index we can outperform that index over time.