When it comes to investment risk and reward and the ever-popular use of both single and multi-asset risk rated funds, proper strategic portfolio construction and rebalancing is essential. But it also requires more nuance than a simple reliance on ESMA risk scales.
When it comes performance, a deeper understanding of ESMA and risk buckets is all important, as a simple reliance on one or two ESMA risk rated funds, with annual reviews is limited. While the ratings offer a general guide, a client’s individual risk tolerance and investment goals should be carefully considered alongside the ratings.
ESMA Risk Scales
The majority of risk-rated funds/portfolios are built around the ESMA scale, which was developed by EU regulators (European Securities and Markets Authority). This scale (from risk level 1 to 7) is based on the volatility of a fund’s returns over the past five years. Greater volatility implies a higher risk level (loss potential), but also better return potential. Here’s a chart of the ESMA scale:
Paying attention to the volatility bands, a fund with a ‘4’ rating (medium risk) could expect to experience upside or downside of between 5% to 10% at any point in time.
Market corrections, defined as a 10% or more decline from a recent peak, are a relatively frequent occurrence in financial markets. They typically happen about once a year, though the exact timing and length can vary, but these corrections tend to be short-lived, resolving within a few weeks to several months, so a over reaction is seldom warranted.
However, in choosing to sit in a ESMA risk bucket, you should understand that the volatility range is “expected”; “actual” range can be different and what happens if we enter a bear market?
A bear market is defined as a decline of at least 20% from recent highs in major stock indexes like the S&P 500. Unlike a correction, a bear market doesn’t just nibble at your portfolio; a bear will claw hard at it.
In Summary
It’s is our view that ESMA risk ratings should act as a guide, but investment portfolio construction should then go deeper than simply sitting in a risk bucket (EMSA Scale) until your next annual review.
ESMA is a practical and easily understood method to reflect an investor’s risk/reward profile, but we believe that investors need an additional line of defense with a more nuanced approach to risk management or in short, that a deeper level of risk management should actually apply.
When working with One Quote Financial Brokers, this means hedging against downside risk and making sure that your portfolio remains correctly aligned, with targeted returns in mind.
Diversification & Style
If there’s one lesson that both bear markets and corrections teach us, it’s the value of diversification i.e. spreading your investments across various asset classes, sectors, and geographical regions to reduce risk and ESMA does reflect this, but investment management style also plays a very important part as market conditions will inevitably change.
The Bottom Line
- As you shop the market for fair, competitive and transparent charges, really look to understand what you’re paying for and how well your investment is protected from downside risk.
- Carefully consider your investment goals, ability to take risk and be realistic in your time horizon.
- Be confident in the monitoring and review strategy, which should lead to a long-term supportive professional relationship.
We have designed an investment process, based on a personalised and strategic risk-managed approach, so please contact us to learn more.
Free Investment Consultation
To arrange a free initial 30-minute consultation by phone, or video call, please contact us today. Contact: Ken O’Gorman – Director – CB, QFA, RPA, SIA – One Quote Financial Brokers on: 01 845 0049 or email: ken@onequote.ie
Or enquire online and give us a quick outline of how we can help.
