How much risk should a charity take in order to meet its financial objectives? Understanding both how much risk a charity is willing to bear and how important its income objective is can be vital to working out a strategy for it.
To professional investors, risk falls principally into two categories: the prospect of performance diverging from the client's benchmark, and the volatility of either total returns or capital values. The more returns vary from year to year, the less certainty there is of an 'average' return being achieved in any short-term period. Over a longer timeframe the dispersion of actual annualised returns, when compared with expectations, is much reduced.
Long-term data from markets show that the lowest level of predictability of capital values in the 'mainstream' asset classes is exhibited by equities, followed, in ascending order, by corporate bonds, government bonds, commercial property and cash.
Unsurprisingly, reward from these asset classes - as measured by total returns - comes in almost inverse order, the only exception being commercial property, which has demonstrated better returns than both corporate and sovereign bonds but with greater certainty of those returns being achieved.
To achieve a high real rate of return over the longer term, we must devise an investment policy to achieve this outcome. This requires us to invest in more volatile assets, such as equities, in order to generate these returns. Consequently, we would have fewer lower-risk assets, such as cash or bonds.
Investors should also consider the riskiness of individual investments in their portfolios. This could be defined as either the chance of something going wrong or the market price changing dramatically.
For example, in 1973/74, long- dated gilts fell 40 per cent in value because investors felt the risk of inflation had risen significantly. This meant investors saw sharp falls in their capital even though they were invested in an instrument backed by the government. Charities keen to avoid risk while maximising income should be aware that investing in government bonds can end up being a higher risk than they thought.
Growth in portfolio
On a more positive note, the predictability of a portfolio's income is substantially higher than that of its capital. However, trustees need to watch out for any undue concentration in the source of dividends: when BP suspended payments of dividends after the oil spill in the Gulf of Mexico in 2010, those dividends represented 11 per cent of all those paid by the entire UK stock market and as much as 5 to 6 per cent of many investors' total portfolio income.
For many charities, growth in portfolio income over time is as important as the size of incomes and requires investment in assets such as equities that carry greater capital volatility, as well as some sensitivity to potential recessions.
John Hildebrand is an investment manager at Investec Wealth & Investment