In developing appropriate investment strategies, one of the most important considerations is risk tolerance.

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1 Investment Risk Explained Introduction In developing appropriate investment strategies, one of the most important considerations is risk tolerance. Risk is an unavoidable part of the investment process. It may be controlled by careful portfolio construction but it can never be eliminated. Even cautious investors who believe there is no risk in a building society investment are exposed to the risk that the net interest rate will not match the rate of inflation so that the real value of their capital is eroded. There is an additional risk that only the first 85,000 of capital is protected in the event of collapse of the financial institution. Investment Sectors Risk Scores 1-10 We consider three principal factors when determining the risk score of each individual investment sector e.g. UK Gilt, UK Equity Income, Global Equity etc. 1: Volatility. Volatility is a measure of price fluctuation often quoted as Standard Deviation and this is described in more detail later in this document. In simple terms, higher standard deviation means higher volatility (i.e. greater price fluctuation). Increasing volatility infers greater potential losses and profits. A cash fund will typically have very low volatility whilst an emerging market equity fund will exhibit high volatility. The 3 year standard deviation of each investment category is specified in Table 2. 2: Historic Losses. Table 2 gives the discrete annual performance (%) for each category of investment. Worst years are shown in red and best years are shown in blue. 3: Security. In considering risk we also look at the security of a particular asset. An example of this is that Gilts (bonds issued by the UK government are generally considered safer than other fixed interest securities (e.g. bonds issued by companies). The year 2008 was a very bad year for most asset classes but gold performed very well. This performance can be attributed to the fact that many investors consider gold to be a safe haven, however based on price volatility alone gold would appear to be more risky. 1 is the lowest level of risk and 10 is the highest (refer to Table 1). Central Independent Advisers is a trading name of Piggybank UK Limited Piggybank UK Limited is Authorised and Regulated by the Financial Services Authority. FSA No Registered in England and Wales No Tel Registered Office: Avening, Lower End, Alvescot, Bampton, Oxfordshire, OX18 2QA.

2 Risk Categories Each investment sector has been placed in a broader category of risk. Very Low (VL): Investment returns are normally fairly predictable but may not give full protection against inflation. This category includes cash and other money market related instruments. There is little chance of capital values falling (unless the institution holding your money gets into serious financial difficulty). You can expect to receive interest on your savings though rates do rise and fall. During periods of very low interest rates certain cash based funds can deliver negative returns. There is no capital appreciation and even reinvestment of interest payments is likely to achieve no more than capital preservation in real terms. Low (L) Low risk investments are generally aimed at risk averse investors seeking a better return than cash. Returns may not be as high as other investments but volatility should be lower. This category includes fixed interest securities and UK direct property. It should be noted that in extreme adverse conditions capital values have been known to fall by more than 20% in one year. Medium (M) Within this category we include high yielding fixed interest securities, balanced managed funds and equity funds predominantly investing in UK Blue Chip Shares. There is potential for good capital growth and/or rising income particularly in the medium to long term. However, it should be noted that there remains a real risk of capital loss particularly in the short to medium term with some UK Equity funds experiencing falls in excess of 30% in one year during adverse market conditions. Higher (H) Generally equity based investment subject to significant price variation. Potential for significant capital appreciation but with a higher risk of capital loss particularly in the short term. This category includes overseas equities and global property which expose investors to an additional risk of currency fluctuation. It also includes UK Small & Mid-Cap funds and certain UK Blue Chip Shares. Speculative (S) This involves specifically targeted assets that may expose capital to significant volatility. Very high risk investments have the potential for delivering exceptional returns but investors should be prepared to take losses as well as gains. It is possible with certain speculative investments to lose everything. Note The above risk categories are based on medium term investment (5 Years +). Increasing the length of time an investment is held (duration) tends to reduce investment risk and the chance, and/or extent, of any loss being realised.

3 Table 1 Category/Sector Description Risk Very Low 1 Cash Bank & Building Society deposits. 1 Money Market Funds comprising cash & other interest bearing assets. 1 Deposit & Treasury Short term debt issued by the UK Government. 1 Low Risk 1-4 UK Gilt Government loan stock. 2 Sterling Fixed Interest Mix of Gilt & Bond 2 UK Corporate Bond Largely investment grade corporate debt. 3 With Profits Insurance funds with attaching bonuses. 3 Strategic Bond Fixed Interest with a range of Credit Ratings. 3 Mixed (0%-35% Equity) Mixed assets with a maximum 35% equity content. 3 Absolute Return Cautiously managed funds targeting specific returns. 3 Global Bond Overseas Fixed Interest Securities. 4 Gold Precious metal. 4 Cautious (20%-60% Equity) Mixed assets with a maximum 60% equity content. 4 UK Direct Property Funds investing directly into commercial property. 4 Medium Risk 5-7 Mixed (40%-85% Equity) Mixed assets with a maximum 85% equity content. 6 Sterling High Yield UK high yielding Fixed Interest securities. 6 UK Equity Income Typically high yielding UK Blue Chip equity fund. 6 Global High Yield Overseas high yielding Fixed Interest securities. 7 UK Property Shares Property funds investing in Property Shares. 7 UK Equity Broad based UK equity funds. 7 Higher Risk 8-9 Global Equity Global equity funds. 8 UK Mid-Cap Predominantly investing in UK Mid-Cap securities. 8 Global Property Direct or indirect investment in overseas property. 8 European Equity At least 80% invested in European securities. 8 North American Equity At least 80% invested in North American securities. 8 Japan Equity At least 80% invested in Japanese securities. 8 Asia Pacific incl. Japan Eq. At least 80% invested in Far Eastern securities. 9 Asia Pacific excl. Japan Eq. At least 80% invested in Far Eastern securities. 9 US Smaller Companies Fund investing in US smaller companies. 9 European Smaller Co. Fund investing in European smaller companies. 9 UK Smaller Companies Fund investing in UK smaller companies. 9 FTSE 100 Stocks FTSE 100 listed stocks. 9 Speculative 10 Japanese Sm. Co. Japanese smaller companies. 10 BRIC Brazil, Russia, India & China. 10 Emerging Markets Other non-bric Emerging Markets. 10 Other Shares UK stocks not included in the FTSE 100 index. 10 Specialist Various including VCT, EIS, Commodity, Energy etc. 10 Risk scores are based on investments being held for the medium to long term (2-5 years). Market related risk tends to increase as duration decreases. Refer to the following Table 2 for a 10 year history showing for sector average returns, 3 Year Standard Deviation and Risk Score

4 Table 2 UK ABI Pension Sectors Performance % Annlzd Annlzd Volatility Risk UK Unit Trust Sectors * Years 5 Years 3 Yr SD Score Very Low Risk: Score 1 Deposit & Treasury Money Market Low Risk: Scores 2-4 UK Gilt Sterling Fixed Interest Mixed (0% - 35% Equity) Sterling Corporate Bond Strategic Corporate Bond* Global Fixed Interest UK Direct Property Mixed (20% - 60% Equity) Medium Risk: Scores 5-7 Mixed (40% - 85% Equity) Sterling High Yield UK Equity Income UK Equity Higher Risk: Scores 8-9 Global Equity (up to 100% Equity) Europe excl. UK Equities North American Equity Japan Equity Asia Pacific incl. Japan Equity Asia Pacific excl. Japan Equity UK Smaller Companies European Smaller Companies* North American Smaller Speculative: Score 10 Global Emerging Markets Equities Commodity/Energy Japanese Smaller Companies*

5 Yearly Performance Histogram Mixed (0%-35% Equity) Mixed (20%-60% Equity) Mixed (40%-85% Equity) Up to 100% Equity Key Risk Score 3 Risk Score 4 Risk Score 6 Risk Score 8

6 Overall Risk Score Systemic risk is the risk of collapse of an entire financial system or entire market. Systemic risk can t be reduced through diversification. We can however limit fluctuations in capital values by diversification of a portfolio by investing across sectors and asset classes. The overall risk score reflects the risk of the entire portfolio and is typically lower than the weighted average of the constituent holdings due to the benefits of diversification. Types of Risk Market risk the risk that there might be a reduction in values as a result of a fall in the stockmarket generally such as happened in the periods , 1987, and Investment-specific risk - the risk that there might be a reduction in value as a result of some event or circumstance related to a specific company. e.g. BP. Interest rate risk. A gilt-edged security or other fixed interest security falls in value as a result of a rise in interest rates Credit risk this includes the risk that the value of a fixed interest investment will fall when other investors decide that the probability of default has increased. Default is when the issuer of the investment fails to pay the interest or repay the capital. Credit risk also includes the risk of a fixed interest issue being downgraded or the pricing of credit risk changing, which is reflected in credit spreads Inflation risk the risk that the real value of the investment and the income from it will fall because of inflation. Reinvestment risk when income received during the life of an investment cannot be reinvested at the predicted rate. Business risk. For example, the management of a company might make poor business decisions or a whole industry could go into decline. Currency Risk. Where investment is overseas, sterling may appreciate against the investing currency. If sterling is strong against the US dollar, capital growth can be eliminated from investment in US markets. Political risk the risk that a new or changed government will have different fiscal and monetary objectives. This may be a result of the democratic process or it may occur through a coup or revolution. Liquidity risk. The investment may be difficult to sell or encash. Unlisted securities are almost always hard to sell. Settlement or counterparty risk. The counterparty to a transaction may fail to settle. Event Risk. This often refers to the issuer of a security being unable to pay interest or repay capital due to a major unexpected event such as a natural disaster, war or even a corporate change such as a takeover.

7 Normal Distribution & Standard Deviation Standard deviation is a useful measure of risk based on historic data, and to help you understand this concept, it can help to learn about what statisticians call normal distribution of data. A normal distribution of data means that most samples in a set of data are close to the "average," while relatively few samples tend to one extreme or the other. The x-axis (the horizontal one) is the value in question, e.g. annual performance of a set of investments such as UK Equity. The y-axis (the vertical one) is the number of data points for each value on the x-axis e.g. the number of funds achieving a specific return. The standard deviation is a statistic that tells you how tightly all the various samples are clustered around the mean in a set of data. When the samples are tightly bunched together and the bell-shaped curve is steep, the standard deviation is small. When the samples are spread apart and the bell curve is relatively flat, that tells you there is a relatively large standard deviation. Not all sets of data will have graphs that look this perfect. Some will have relatively flat curves, others will be steep. Sometimes the mean will lean a little bit to one side or the other. But all normally distributed data will have something like this same "bell curve" shape. One standard deviation away from the mean in either direction (i.e. +/- 1 SD) on the horizontal axis accounts for somewhere around 68 percent of samples in a group. Two standard deviations away from the mean (+/- 2 SD) account for roughly 95 percent of the samples and three standard deviations account for about 99 percent. If this curve were flatter and more spread out, the standard deviation would have to be larger in order to account for those 68 percent or so of the sample population. So standard deviation can tell you how spread out the samples in a set are from the mean.

8 Standard Deviation & Fund Returns The standard deviation of a fund measures how much a fund s total returns have fluctuated in the past. The term volatility is often used to mean standard deviation. This number is useful for two reasons. Firstly, because the more a fund s return fluctuates, the riskier the fund is likely to be; standard deviation facilitates comparisons across all funds, from cash to emerging market equities. Secondly, because funds that have been more volatile in the past tend to be the more volatile in the future. In that sense, standard deviation is a useful warning sign. The standard deviation is expressed in percentage terms, just like the returns. We calculate standard deviation based on the fund s most recent 36 monthly returns. How to use it? The simplest use is to compare funds. Additionally, you can estimate the range of returns that a fund can experience in any given year. This gives a useful estimate of how low returns can go. To perform this simple estimate requires 2 numbers:- 1. Average Return. 2. Standard Deviation. You can estimate that, 95% of the time, the lowest annual return will be equal to the average return minus twice the standard deviation. Conversely, the maximum typical return, 95% of the time, will be equal to the average return plus twice the standard deviation. Example 1 A money market fund had an annual average return of 6%, with a typical standard deviation of 1%. The typical maximum annual return you would expect is: 6+1+1= +8%; the typical lowest return you would expect is 6-1-1= +4%. In other words, if the fund continues to behave as it has in the past, 95% of the time, its annual returns will be between 4% and 8%. SD % within 3 Yr Mean Variance Min Return Max Return % 6.00% 1.00% 5.00% 7.00% % 6.00% 2.00% 4.00% 8.00% % 6.00% 3.00% 3.00% 9.00% Example 2 An equity fund has experienced an average return of 18%, with standard deviation of 30% (1 SD). Applying the same calculation, you can see that this fund s typical annual returns will be between -42% (18% -2 SD) and a +78% (18% +2 SD). So even in good times, you can obtain an estimate of the downside for a given fund. SD % within 3 Yr Mean Variance * Min Return * Max Return % 18.00% 30.00% % 48.00% % 18.00% 60.00% % 78.00% % 18.00% 90.00% % % * We are able to estimate extreme returns in such a way, because monthly returns follow more or less a normal distribution.

9 Of course, past volatility is no perfect predictor of future behaviour, but the information provided by standard deviation is too important to be overlooked. Another limitation of volatility is that, if you hold several funds, you can average the returns, but not the volatility: the aggregate volatility is likely to be lower than the average of the various funds individual volatilities. That is the benefit of diversification. 01/03/2012