Provides legal and practical advice on investment risk management.
The importance of risk management in charity investment
Effective risk management is essential for charities to protect their investment assets while achieving sustainable financial growth. All investments carry risk, including market fluctuations, economic downturns, and inflation. However, charities must balance risk with the need for returns to support their mission.
Trustees have a legal duty to manage risk prudently, ensuring that investment decisions align with their charity’s objectives and financial needs. The Charity Commission’s guidance (Investing Charity Money: A Guide for Trustees) emphasises that trustees should:
- Assess and manage investment risks appropriately.
- Diversify investments to avoid overexposure to any single asset or sector.
- Regularly review the risk profile of their investment portfolio.
- Ensure investment policies align with their charity’s long-term financial goals.
Market risk
- The risk that investment values fluctuate due to economic conditions, interest rates, or geopolitical events.
- Example: Stock market downturns affecting equity investments.
Inflation risk
- Inflation can erode the real value of investment returns over time.
- Example: A low-interest savings account may not keep pace with inflation, reducing purchasing power.
Liquidity risk
- The risk of not being able to access funds when needed without incurring losses.
- Example: Investing heavily in property may limit the ability to sell assets quickly in a financial emergency.
Credit risk
- The risk that a borrower or bond issuer defaults on their payments.
- Example: A charity investing in corporate bonds could lose money if the company goes bankrupt.
Regulatory and legal risks
- Changes in laws, taxation, or regulations can impact investments.
- Example: New environmental regulations affecting certain industries in an investment portfolio.
Reputational risk
- Poor investment choices may harm a charity’s reputation if they contradict its mission or ethical stance.
- Example: A health charity investing in tobacco companies may face criticism from donors and stakeholders.
Diversification is a key strategy for reducing risk and improving the stability of a charity’s investment portfolio. By spreading investments across different asset classes, geographic regions, and industries, charities can mitigate the impact of losses in any single area.
How diversification works
Asset class diversification
- Investing across different types of assets to balance risk and return.
- Common asset classes:
- Equities (Stocks) – Higher risk, higher potential return.
- Bonds (Fixed Income) – Lower risk, stable income.
- Property/Real Estate – Can provide steady returns but may be less liquid.
- Cash and Short-Term Deposits – Low risk, but vulnerable to inflation.
- Alternative Investments (e.g., private equity, infrastructure, commodities) – Provide additional diversification but may carry specific risks.
Sector diversification
- Avoiding overexposure to a single industry to protect against sector-specific downturns.
- Example: A portfolio heavily invested in technology stocks may suffer if the tech sector experiences a downturn.
Geographic Diversification
- Investing in international markets to reduce reliance on the UK economy.
- Example: Holding investments in both UK and global markets can help protect against local economic downturns.
Time diversification
- Investing over time rather than making large investments at once can reduce exposure to market timing risks.
- Example: Regular investment contributions (such as monthly allocations) can help smooth out market volatility.
How charities can manage investment risks effectively
- Assess Risk Appetite and Capacity
- Trustees should define their charity’s risk tolerance, balancing financial needs with acceptable levels of risk.
- This should be outlined in the Investment Policy Statement (IPS).
- Use Professional Investment Management Services
- Many charities work with investment managers or advisors to construct well-diversified portfolios.
- Selecting managers with experience in charity investments ensures alignment with governance and ethical considerations.
- Regular Portfolio Reviews
- Investment performance and risk exposure should be reviewed at least annually.
- Adjustments may be needed based on financial market changes or shifting charity priorities.
- Implement Ethical Risk Management
- Consider ESG (Environmental, Social, and Governance) factors to mitigate risks related to sustainability and reputation, as well as financial risks.
- Ethical screening and engagement with investment managers can align investments with the charity’s mission.
- Use Financial Risk Management Tools
- Hedging Strategies – Derivatives and other financial instruments can help protect against adverse market movements.
- Stop-Loss Orders – Setting limits on losses to automatically sell assets if they decline beyond a threshold.
Resources for risk management and diversification
The Pensions and Lifetime Savings Association (PLSA)
Offers insights on risk management strategies for institutional investors.
Financial Reporting Council (FRC) Stewardship Code
Helps charities engage with investment managers to ensure responsible investment practices.
UK Sustainable Investment and Finance Association (UKSIF)
Provides resources on ESG and responsible investment strategies.
By implementing strong risk management practices and diversifying their investments, charities can safeguard their financial future while maximising the impact of their resources.
Explore the next section
Selecting and working with investment managers.