Does tak­ing greater risk equal greater re­ward with in­vest­ing?

We look for ev­i­dence by analysing 10 years’ worth of data in parts of the funds mar­ket

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The greater the risk, the greater the po­ten­tial re­ward is a com­mon adage in in­vest­ment. Af­ter all, if you could gen­er­ate the best re­turns by in­vest­ing in UK gov­ern­ment bonds (also known as gilts), why would you ever think of putting any money into racier as­sets?

But mea­sur­ing risk is dif­fi­cult, and de­ter­min­ing whether the re­wards are com­men­su­rate with the level of risk you have taken is largely a mat­ter of opin­ion.

Ex­perts mea­sure risk in a num­ber of com­pli­cated ways. One of them is through some­thing known as stan­dard de­vi­a­tion. In in­vest­ment, this fig­ure is a way of ex­press­ing how far a fund sways from its aver­age re­turn. In essence, it shows how volatile the per­for­mance of a fund has been. The greater the stan­dard de­vi­a­tion, the greater the swings up and down in a fund’s re­turns.

It’s a crude mea­sure and by no means a per­fect sci­ence, but it is one way of as­cer­tain­ing how risky a fund may be.

Tom Becket, chief in­vest­ment of­fi­cer at Psigma In­vest­ment Man­age­ment, says: ‘In­vestors should be com­pen­sated for tak­ing higher risk in the form of greater re­turns, but whether this ma­te­ri­alises de­pends on your time hori­zon for in­vest­ing, your pa­tience and ca­pac­ity for risk.

‘Us­ing quan­ti­ta­tive anal­y­sis such as stan­dard de­vi­a­tion can be help­ful to de­ter­mine how funds have per­formed at cer­tain points in the in­vest­ment cy­cle and how they might blend with the rest of your port­fo­lio, but it shouldn’t be the main fac­tor on which you

base an in­vest­ment de­ci­sion.’

WHAT DO THE FIG­URES SHOW?

The cor­re­la­tion be­tween a fund’s stan­dard de­vi­a­tion and its per­for­mance is patchy at best. Anal­y­sis from stock­bro­ker AJ Bell shows the per­for­mance of funds with a track record of at least 10 years, de­tail­ing their stan­dard de­vi­a­tion and an­nu­alised re­turn over that pe­riod, as well as the per­centile rank­ing of the fund within its peer group.

With thou­sands of funds avail­able to UK in­vestors, the ta­bles in this ar­ti­cle show only a snap­shot of the data, il­lus­trat­ing the five funds with the high­est and the low­est stan­dard de­vi­a­tion within the UK All Com­pa­nies, UK Smaller Com­pa­nies and Global in­vest­ment sec­tors.

In the UK All Com­pa­nies sec­tor, greater risk cer­tainly seems to pro­duce greater re­wards: the Stan­dard Life UK Eq­uity Un­con­strained (B7LK223) fund has a stan­dard de­vi­a­tion of 24.24 – sig­nif­i­cantly higher than the peer group aver­age of 14.75 – and it has also pro­duced an an­nu­alised re­turn of 13.9% over the past decade, putting it in the third per­centile of per­form­ers.

Mean­while, the In­vesco Per­pet­ual In­come (BJ04HX6)

fund, which has the low­est stan­dard de­vi­a­tion in the sec­tor, has pro­duced an an­nual re­turn of 7.9% over the same pe­riod.

But, it’s the Lion­trust UK Smaller Com­pa­nies (B57TMD1)

fund which is the stand­out per­former in the UK Smaller Com­pa­nies sec­tor. The fund has the low­est stan­dard de­vi­a­tion of its peer group at 11.65 – com­pared to an aver­age of 15.64 – and has pro­duced a stonk­ing an­nu­alised re­turn of 18.6% over the past 10 years, putting it in the third per­centile.

Mean­while the aver­age UK smaller com­pa­nies fund has an an­nu­alised re­turn of 13.8% over the same pe­riod and Janus Hen­der­son UK Smaller

Com­pa­nies (0744762), the fund with the high­est stan­dard de­vi­a­tion, achieved 14.8%. In the Global sec­tor, mean­while, the two funds with the high­est stan­dard de­vi­a­tion have pro­duced neg­a­tive an­nu­alised re­turns over the past decade.

TAK­ING RISKS DOESN’T GUAR­AN­TEE RE­WARDS

Wes­ley McCoy, man­ager of the SLI UK Eq­uity Un­con­strained fund, says: ‘Peo­ple think of vo­latil­ity as risk and as a bad thing, but it cre­ates the op­por­tu­nity to make money. But tak­ing risk doesn’t guar­an­tee re­wards, that isn’t how it works.

If an in­vest­ment is of­fer­ing you a high re­turn, there’s a rea­son for that. It’s rare to find a high re­turn in some­thing that is very cer­tain.’

He says pe­ri­ods such as Brexit and the global fi­nan­cial cri­sis, when stock mar­kets are at their most volatile, are when his fund has pro­duced some of its strong­est re­turns. He ex­plains: ‘We’re look­ing for com­pa­nies that are mis­priced or mis­un­der­stood by the mar­ket, where a volatile share price is ex­press­ing some­thing that won’t mat­ter in years to come.’

He points to Lad­brokes Coral as one re­cent ex­am­ple where the stock fell out of favour amid con­cerns about a gov­ern­ment crack­down on the bet­ting in­dus­try. In the end, the share price shot up as the com­pany was bought by GVC (GVC).

STRATE­GIC MOVES

Vic­to­ria Stevens, co-man­ager of the Lion­trust UK Smaller Com­pa­nies fund, aims to re­duce risk by only tak­ing small po­si­tions in stocks that the team deem as be­ing po­ten­tially riskier. She says: ‘This is es­pe­cially im­por­tant in the small cap mar­ket, where in­di­vid­ual stocks can be very volatile.’

To limit risk the team looks for com­pa­nies with strong bar­ri­ers to com­pe­ti­tion as well as those where the di­rec­tors have a large stake in the busi­ness. The fund veers to­wards qual­ity com­pa­nies, which are ‘ro­bust, de­pend­able and bet­ter able to weather ex­ter­nal eco­nomic shocks’.

Becket at Psigma adds: ‘Peo­ple should take any mea­sure­ments such as stan­dard de­vi­a­tion with a huge pinch of salt be­cause, ul­ti­mately, they tell you about the past and not the fu­ture. Just be­cause some­thing has or hasn’t been volatile in the past doesn’t mean that will con­tinue in the fu­ture.’

Lad­brokes Coral’s stock fell out of favour amid the gov­ern­ment crack­down on the bet­ting in­dus­try

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