Risks of Investing

Introduction
If an individual is prepared to invest, then that individual must be prepared to take on some risk. The attitude to risk of different investors can vary and it is for this reason why YTM Stockbrokers is committed to developing a clear and mutual understanding of risk with its clients. You are urged to contact us if you have any questions or concerns relating to the risks to which your investments may be exposed. YTM Stockbrokers can provide you with the necessary advice for managing the risk of your investments.

The following chart gives you an idea of risk and return. Generally the lower the risk, the lower the potential reward.

This document provides a brief description of the nature and risks of the following range of investments, which are available through our stockbroking services:

1. Cash Deposits - Bank and Building Society Accounts
2. Shares - UK and Overseas 
3. Bonds / Gilts - Government and Corporate Fixed Interest Securities
4. Unit Trusts and Open Ended Investment Companies (OEIC’s) 
5. Investment Trusts 
6. Structured Products 
7. Futures, Options and Warrants
8. Contracts For Difference (CFD) and Spread Betting
9. Hedge Funds and Unregulated Collective Investment Schemes
10. Unquoted Investments

It is important that you understand that the price and value of investments and their incomes fluctuate. You may get back less than the amount you invested, possibly losing the total investment. Trading derivatives may require you to pay more at a later date. Changes in exchange rates may also cause your investment to go up or down in value. If in doubt please seek further advice. Past performance is not necessarily a guide to future performance.

1. Cash
Cash Deposits are mainly for ‘Savings’ rather than ‘Investment’ but we mention them here as it is considered one of the four main asset classes (Cash Deposits, Shares, Bonds and Property). Cash Deposits are an excellent place for money needed for the short term and for emergency funds.

Cash Deposits are generally considered to be safe. There are only usually problems if the bank or building society becomes insolvent, albeit this is very rare. The downside is that the returns may not be particularly attractive over the long term. The effect of inflation risk on your money means that the money you save will buy less each year. To protect against this you should look for an after-tax interest rate that is more than the rate of inflation.

Risks
Using Cash Deposits to save for the long term, say for retirement, run a higher risk in the fact that one might not have as much money as need than if had they invested in a personal pension scheme, for example.

One must understand that any investment (even cash) carries risk. The purchasing power of Cash Deposits (Cash) is subject to inflation risk. A 3% inflation rate erodes the purchasing value of cash by 50% (over a 23 year period); whereas inflation at 5% achieves the same eroding effect in only 14 years (reducing it by almost 75% over a similar 25 year period).

2. Shares
You can buy shares as part of a pooled investment or directly, when you buy through the stock market. Shares are also known as equities or stocks. When you buy shares direct in a company, you are buying a part of that company, and you become a shareholder, which usually means you have the right to vote on certain issues. You can either buy new shares when the company starts up and sells them to raise money (through an Initial Public Offering (IPO) or a Rights Issue), or buy existing shares which are traded on the stock market.

The aim is for the value of your shares to grow over the longer term as the value of the company increases in line with its profitability and growth. In addition, you may also receive dividends, which is an income paid out of the company’s profits. Longer-established companies usually pay dividends whilst growing companies tend to pay lower, or no, dividends. With smaller, less established companies you would typically be hoping for better capital growth.

Risks
The level of a stock market goes up or down as the prices of the shares that are the constituents of that market go up or down. The main factor determining the price of a share is the perception of its current value to its owner. One factor that could affect the price of a share is a change in opinion as to how well the company itself is performing or could perform in the future. This opinion is frequently based on predictions about the economic conditions in which a company is operating, which is why stock markets are largely affected by economic conditions.

If you are investing in shares you should expect the value of your investment to go down as well as up, and you should be comfortable with this. Holding a limited number of equities that do not provide adequate diversification can result in this risk being exacerbated, and investors in individual equities should be particularly aware of the risks inherent in such an investment strategy (i.e. the Specific Risks of those securities).

YTM Stockbrokers categorises single equities as higher risk, and equity investment, by way of a diversified portfolio of equities as more ‘medium’ risk. If you have a wide range of shares (a diversified portfolio) you are very unlikely to lose all your money. It is important to stress that you need to be looking to the long term when investing in shares – at least five years but preferably longer (more than ten years). The FTSE 100 Index commenced at a base value of 1000 on 3rd January 1984.

Investing in overseas companies (shares) is subject to Currency Risk as a result of exchange rate fluctuations. If, for example, you buy US dollar denominated stock and the dollar declines against the pound, then the sterling value of the stock will decline, even if the actual dollar share price remains the same. This will impact the performance of your portfolio as a whole.

3. Bonds or Fixed Interest Securities
A bond is a loan to a company, government or a local authority. Generally, interest is paid to you as the lender and the amount of the loan repaid at the end of the term, providing it is redeemable. There are many names for this type of investment, for example:

1. Loan Stock
2. Debentures
3. Debt Securities
4. Gilts (Loans to the Government)
5. Corporate Bonds (Loans to Companies)

The main benefit of these investments is that you normally get a regular stable income. They are not generally designed to provide capital growth. Bonds have a nominal value. This is the sum that will be returned to investors when the bond matures at the end of its term. Most bonds have a nominal value of £100. Because bonds are traded on the bond market, the price you pay for a bond may be more or less than £100. There are several reasons why the price might vary from the nominal value, for example:

• If a bond is issued with a fixed interest rate of, say, 8% and general interest rates then fall well below 8%, then 8% will look like a good yield and the market price of the bond will tend to rise - perhaps from £100 to £110 or £120.
• The reverse is also true. If interest rates rise, the fixed rate of a particular bond might become less attractive and its price could fall below £100.
• Ratings agencies might take the view that a particular Company's bond no longer qualifies for a high rating (The Company, for instance, may not doing as well as it was when the bond was issued). If this happens then the market price of the bond might fall. On the other hand, the company's rating may be improved leading to a price rise. 
• The inflation rate might start to go up and the interest rate on some bonds might start to look less attractive compared with other investments.

Risks
Ignoring the inflation risks outlined above, bonds are generally less risky than shares. One of the main risks associated with Corporate Bonds is that the company you have lent money to can't pay the interest due or cannot pay the money back at the end of the term. It is generally considered that these risks do not apply to gilts, as a government is expected always to pay in full (although there have been instances of certain countries having been unable to repay). Bonds issued by governments will usually pay a lower rate of interest as a result of the perception that they are less risky.

Companies have different credit ratings and a company with a high credit rating is regarded as safer than a company with a lower credit rating. Companies with a lower credit rating will have to offer a higher rate of interest on their bonds than companies with the top credit rating, simply to attract investors and to compensate them for the higher risk.

Bonds can be bought and sold in the market (like shares) and their price can vary from day to day. A rise or fall in the market price of a bond does not affect what you would get back if you hold the bond until it matures. You will only get back the nominal value of the bond in addition to any coupon payment to which you've been entitled during your ownership of the bond, irrespective of what you paid for it. If you paid less than the nominal value then you will have made a capital gain when the bond matures; and a capital loss if you paid more than the nominal value. This only applies if you buy a single corporate bond. It doesn't apply to bond funds because these invest in many different bonds so there is no single maturity date for your investment.

4. Unit Trusts and Open Ended Investment Companies (OEIC’s)
Unit trusts and OEIC’s are the most common form of Collective Investment Schemes in the UK. These are funds run by fund management companies. In Europe they are called UCITS schemes, which are permitted under European legislation to be sold in the UK. They are called open-ended investments as the number of units/shares in issue increases as more people invest and decreases as people take their money out.

As an investor, you buy units/shares in the hope that the value rises over time as the prices of the underlying investments increase. The price of the units/shares depends on how the underlying investments perform. You might also get income from your units/shares through dividends paid by the shares (or income from the bonds, property or cash) that the fund has invested in.

When you buy units/shares in a fund, you usually pay an initial charge. How the charge is shown depends on how the price is worked out. For most unit trusts, you buy units at the offer price and sell them at the bid price. The bid price is lower than the offer price and the difference is called the bid/offer spread. These funds are referred to as being dual-priced. The initial charge is usually part of the bid/offer spread, which can often be around 5%.

For OEIC’s, there is no difference between the buying and selling price of units. Because of this, the funds are referred to as being single-priced. If there is an initial charge, it is added to the single price when you buy units, and there may also be an exit charge when you sell units. Between them, these charges are likely to represent around 5% of your investment, so you may end up paying the same level of charges in a single-priced fund as in a dual-priced fund.

YTM Stockbrokers has negotiated a reduction down to the creation price on a large number of funds, so please speak to your broker about the charges that will apply to specific investments. Some funds have no initial charge, but there may be an exit charge instead when you withdraw your money by selling units.

The fund management company takes an annual management charge directly from the investment fund. There are also other costs like dealing charges, custodian fees for example. These costs, along with the annual management fee, are called the total expense ratio (TER). The TER is therefore an estimate of the total ongoing costs of the investment.

Tax
For income, there is a difference in the tax position between funds investing in shares and those investing in bonds, property and cash.

Income (dividends) paid by shares within an open-ended investment fund is assumed to be paid after taking 10% tax (the tax credit). These dividends, when paid out of the fund to you, are not subject to any tax if you are a basic-rate, lower-rate, or non-taxpayer. If you are a higher-rate taxpayer then you have an overall tax rate on dividends of 32.5% of the gross dividend (but you can deduct the 10% tax credit). Non-taxpayers cannot reclaim this 10% tax credit.

Income paid by bonds, property or cash within an open-ended investment fund is paid net of 20% tax. For funds investing principally in these asset classes, no further tax is due if you are a basic-rate, lower-rate, or non-taxpayer. If you are a higher rate taxpayer then you will have to pay an additional 20% tax. However, unlike funds investing in shares, if you are a lower-rate or non-taxpayer then you can reclaim the appropriate amount of tax paid.

Whichever type of open-ended investment fund you have, you can reinvest the income to provide additional capital growth, but the taxation implications are as if you had received the dividend income.

No capital gains tax (CGT) is paid on the gains made on investments held within the fund. But, when you sell, you may have to pay capital gains tax. However, bearing in mind that if taper relief and the personal CGT allowance (£9,600 for the 2008/09 tax year per individual) is available it is often possible to avoid all CGT.

Please note that this is only a summary of the tax position at April 2008. You should be aware that tax legislation changes constantly and you should find out the most current position.

Risks
Open-ended investment funds generally invest in one or more of the four major asset classes - Cash Deposits, Shares, Bonds and Property. Most invest primarily in shares but a wide range also invests in bonds. Few invest principally in property or cash deposits. Some funds will spread the investment and have, for example, some in shares and some in bonds. This can be useful if you are only taking out one investment and want to spread your investment across different asset classes. The level of risk will depend on the underlying investments and how well diversified the open-ended investment fund is. For example, a fund which invests only in one industrial sector, such as technology, will invariably be more risky than funds that invest across the whole range of companies in a market.

Some funds might also invest in derivatives, which may increase the risk profile of a fund. However, fund managers often buy derivatives to help offset the risk involved in owning assets or in holding assets valued in other currencies.

All money in an open-ended investment fund is protected by a trustee or depository who ensures the management company is acting in the investors' best interests at all times. Like shares, if the fund you invest into is denominated in a currency other than sterling, exchange rate movements will impact upon the value.

5. Investment Trusts
An investment trust is a company with shares, and another form of collective investment scheme. Unlike an open-ended investment fund, an investment trust is closed-ended. This means there are a set number of shares available, and this will remain the same no matter how many investors there are. This can have an impact on the price of the shares and the level of risk of the investment trust. Whereas open-ended investment funds create and cancel units/shares to suit the number of investors, closed ended investment funds do not, therefore a buyer needs to find a seller and vice versa, a seller needs to find a buyer.

Shares of an investment trust are generally traded on the stock market, in the same manner as shares of any other company. You usually pay dealing charges when you buy and sell investment trust shares, and the difference between the prices at which you buy and sell (the bid/offer spread) is a charge of purchasing an investment trust. There is also an annual management fee which comes out of the investment fund.

Risks
The price of the investment trust shares depends on two main factors:

1. The value of the underlying investments. In this respect it works in the same way as open-ended investment funds.
2. The popularity (or unpopularity) of the investment trust shares in the market.

This second point applies only to investment trusts, not to open-ended investment funds or life assurance investments. The reason is because it is closed-ended with a fixed number of shares. If there is a high demand for something, but limited supply, then the price goes up. Conversely, if there is a small demand then price will need to fall until someone is prepared to buy. Put simply, it is influenced by the economic laws of supply and demand.

The result is that investment trust shares do not simply reflect the value of the underlying investments; they also reflect their popularity in the market. The value of the investment trust’s underlying investments is called the Net Asset Value (NAV). If the share price is exactly in line with the underlying investments then it is called trading at par. If the price is higher as the shares are popular then it is called trading at a premium and if lower, trading at a discount. This feature may make them more volatile than other pooled investments (assuming the same underlying investments).

Investment Trusts are also able to borrow money to invest, which is called gearing. Gearing improves a trust's performance when its investments are doing well. However, if its investments do not do as well as expected, gearing lowers performance.

For example, if the investment trust is made up of £50m of investors' money and £50m of borrowed money, then the total fund available for investment is £100m. Say the value of the fund goes down by 10% as a result of losses in the stock market, the value of the overall fund falls from £100m to £90m. However, bear in mind that the borrowing is still £50m and so the remaining £40m belongs to the investors. Although the overall fund went down by 10%, the investors' money has gone down by 20% (i.e. from £50m to £40m). In short, gearing boosts gains, but also magnifies losses.

Not all investment trusts are geared and deciding whether to borrow and when to borrow, is a judgement the investment manager makes. A gearing figure of 100 implies that an investment trust is not geared. Any figure over 100 shows the proportion of its total investments that is borrowed. For example, a gearing figure of 120 means that borrowed money amounts to one-sixth of a trust's total investments.

An investment trust that is geared is a higher risk investment than one which is not geared (assuming the same underlying investments).

6. Structured products
These are usually share-based investments from banking, life assurance or investment management firms. They can be offered as open-ended investment funds, life assurance investments or even cash deposits. If the investment does not perform as well as expected you could lose some or all of the money you invested (your capital).

Risks
‘Capital at risk’ investments, high income investments or guaranteed stock market investments are all types of structured products. ‘Capital at risk’ investments are usually offered as special investments available for a limited time, typically a couple of months. They usually have a fixed term which tends to be around five or six years. Each investment works in a different way but there are two main formats:

1. High Income Growth. These investments offer a high level of income, usually more than a bank or building society account. This income is usually fixed for the term. However, the return of your capital at the end of the term is not guaranteed. You would usually only get all your money back so long as, for example, the stock market had not gone down more than a stated amount. If the stock market falls by more than the stated amount, you will get back less than your original investment at the end of the term. You should make sure you fully understand the amount you could lose before investing in a structured product.
2. Capital Growth. This works in almost exactly the opposite way. With these investments your original investment is usually guaranteed at the end of the term. You do not get income, you get capital growth only. The part that is not guaranteed is how much growth you get. This is usually based on stock market returns; for example you may get back the rise in the FTSE100 index (the index of the top 100 UK firms). You don't however receive the dividend income that you would receive if you owned the shares in the stock market directly or through an investment in another type of pooled investment.

7. Futures, Options & Warrants
Please note, you will not be able to trade in warrants, options or futures unless we are satisfied that you have adequate knowledge and experience to fully understand the nature and risks of these investments. If you are interested in these types of investments please contact your broker for further information.

• Futures are defined as a standardised, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date. One of the most widely traded derivatives of today; Futures are normal buy or sell contracts, exercisable at a future date (the delivery date) and typically will run for up to 12 months. When that delivery date falls due, the holder of the futures contract is obliged to take or make delivery of the product specified within the futures contract. Futures contracts are transferable between parties.

• Options are contracts that give its owner the right, but not the obligation, to earthier buy or sell a specified underlying asset at specified price for a specified date in the future.  An options contract is very similar to a futures contract. The essential difference is that a futures contract MUST be traded on the delivery date, whereas delivery is optional for an options contract. An Option contract conveys the right, but not the obligation, to engage in a future transaction on an underlying security at a fixed price. For example, a call option provides the right to buy some amount of a security at a set strike price at some time on or before the expiration date, while a put option provides the right to sell. The decision on whether to exercise the right to buy or sell will depend upon the value of the underlying security at the time and whether this will result in a profit or not.

• Warrants are a form of traded option, which offer the right to subscribe for shares or bonds (issued by a company or government) and is exercisable against the original issuer of the underlying security, at a specific price within a specified time span. A relatively small movement in the price of the underlying security results in a disproportionately large movement (unfavourable or favorable) in the price of the warrant. The price movements of warrants can therefore be extremely volatile.

Risks
Whilst gains can be unlimited for certain futures positions, equally losses can be unlimited. The unlimited downside attributable to futures contracts is avoided when investing in certain option positions. Buying options involves less risk than writing options because, if the price of the underlying asset moves against you, you can simply allow the option to lapse. The maximum loss is limited to the premium, plus any commission or other transaction charges.

When writing an option, the risk involved is considerably greater than buying options. You may be liable for margin to maintain your position and a loss may be sustained well in excess of any premium received. Furthermore, when writing an option, you accept a legal obligation to purchase or sell the underlying asset if the option is exercised against you, however extreme the market price has moved away from the exercise price.

If you already own the underlying asset which you have contracted to sell (where the options will be known as ‘covered call options’) the risk is reduced. If you do not own the underlying asset (‘uncovered call option’) the risk can be unlimited. YTM Stockbrokers recommend that only experienced investors should contemplate writing ‘uncovered call options’.

It is essential for anyone who is considering purchasing warrants to understand that the right to subscribe is limited in time with the consequence that if the investor fails to exercise this right within the predetermined time-scale then the investment becomes worthless. Transactions in off-exchange warrants may involve greater risk than dealing in exchange traded warrants because there is no exchange market through which to liquidate your position, or to assess the value of the warrant or the exposure to risk. Bid and offer prices need not be quoted, and even where they are, they will be established by dealers in these instruments and consequently it may be difficult to establish what a fair price is.

Please note, you will not be able to trade in Futures, Options or Warrants unless we are satisfied that you have adequate knowledge and experience to fully understand the nature and risks of these investments. If you are interested in these types of investments please contact your broker for further information.

8. Contracts For Difference (CFD) and Spread Betting
A CFD is an agreement made between two parties to exchange, at the closing of the contract, the difference between the opening and closing prices of the underlying share, multiplied by the number of shares detailed in the contract. They are geared (or leveraged) instruments. When trading a share via a CFD, instead of paying the full consideration a margin payment from as little as 10% of the value of the contract may be paid. Consequently you can hold a position up to 10 times greater than would be possible with a traditional investment. Anticipating the right price movement will magnify profits. Conversely, losses can magnify if the price moves against you.

You can choose to buy (‘go long’) of a CFD in the expectation that the price of the underlying equity will rise, or sell (‘go short’) of a CFD if you expect its price to fall. There is a distinct advantage with CFD’s over direct equity investments. The ability of ‘going short’ allows the investor to make money as shares prices fall. Investors can sell shares they don’t actually own, or ‘go short’, in anticipation of buying back at a lower level and profiting from a price fall.

Spread Bets are based on a simple concept. If you think that a financial product (or market) will rise in value, then you may want to buy it (‘go long’). If you think that a certain financial market or product will fall in value, then you may want to sell it (‘go short’). The spread is the difference between the buying and selling price of a financial product. It represents the market-maker's potential profit or loss on a transaction. Like CFD’s, they are inherently high risk investment strategies.

Once you have ‘gone long’ of a financial product that you believe will rise in value, then in due course, if your prediction is correct, you can sell the product for a profit. If you are incorrect and the value falls, you will incur a loss.

Once you have sold a financial product that you believe will fall in value, then in due course, if your prediction is correct, you can buy back the at a lower price, for a profit. (Likewise, if you are incorrect and the value rises, you will sustain a loss.)

Risks
The geared nature if margin traded products, like CFD’s, means that both profits and losses can be magnified. Investors can incur very large losses if their positions move against them. It is less suited to the long term investor; if you hold a CFD open over a long period of time the costs associated increase and it may be more beneficial to have bought the underlying asset.
Furthermore, your rights as an investor diminish when entering a CFD position. One loses the benefit of voting rights as one would have enjoyed holding the underlying asset. The potential risks mean that our CFD service is only available to those clients with a sufficient level of investment experience and understanding.

Financial Spread Betting also carries a high level of risk, therefore you should only speculate with money you can afford to lose. Financial Spread Betting prices can be very volatile and the resulting losses may require further payments to be made. It is not suitable for all customers and requires that you fully understand the risks involved.

9. Hedge Funds and Unregulated Collective Investment Schemes
Hedge funds are exempt from many of the rules and regulations governing other types of funds, which allow them to accomplish aggressive investing goals. Hedge funds' activities are limited only by the terms of the contracts governing the particular fund. They can follow complex investment strategies, being ‘long’ or ‘short’ assets and entering into futures, swaps and other derivative contracts.

Risks
Hedge funds may be geared or include risky or volatile investments such as derivatives. Whilst some hedge funds may be designed to work in the opposite direction to the market (thereby providing protection against falling values in other assets that you may hold), others may not be and the title of hedge fund could therefore be misleading. You should make sure you understand the objectives and risk of the particular fund before investing.

10. Unquoted Investments
Many people now invest in company shares, and the choice of where to buy them from is wide. As well as buying shares in large, listed companies, you can buy shares in smaller companies, traded on markets such as the:

• Alternative Investment Market (AIM)
• Plus Quoted Market; or via an
• Initial Public Offering (IPO) or pre-Initial Public Offering (pre-IPO) - when a company wants to raise money and first offers shares to the public

Shares in such small companies are not listed on a Recognised Investment Exchange. Companies listed on AIM (Alternative Investment Market) are also classified as ‘unquoted’. AIM provides an opportunity for companies to raise capital for expansion, a trading facility and a way of establishing a market value for their shares.

One of the advantages of investing in certain AIM companies is that AIM shares which qualify for Business Property Relief (BPR). Once held for two years, then your investment would normally sit outside of your estate for Inheritance Tax purposes.

More information can be found on the London Stock Exchange website - http://www.londonstockexchange.com/en-gb/products/companyservices/ourmarkets/aim_new/

Risks
Although investing in AIM investments could offer astronomical returns, they also carry a higher degree of risk than investing in more liquid shares of larger companies. The main risks are summarised below:

• They are often smaller, growth companies without proven track records
• There is sometimes a big difference between how much you pay for the shares and how much you can sell them on for
• It can be difficult to find a buyer for some shares - particularly IPOs and pre-IPOs. This could mean that you cannot sell them on when you want to or that you have to accept a much lower price than you paid for them.
• Shareholder influence can sometimes be limited because the majority of the shares may be closely held (e.g. by company directors)
• Publicly available information may be less comprehensive than that provided by listed companies
• There is an increased risk you could lose some or all the capital you invest

 

The descriptions used in this document have been drawn mainly from the Financial Services Authority’s Consumer website: http://www.moneymadeclear.fsa.gov.uk/products/investments/investments.html
Please contact your broker with any queries about investment risk.

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