Richard Baxter, Senior Financial Adviser, looks at the importance of investment risk and adopting different risk positions to suit your life goals.
Whether you’re saving for a specific event such as school fees or retirement, or you are already retired and managing the capital you have saved, it is important to understand risk. Some people are happy to live with calculated risks if it means the chance of a higher return in the long run, whilst others don’t want to lose money under any circumstances.
Investment v Inflation risk
If you are risk averse you may decide to hold capital in cash, so that the actual value doesn’t have a chance to reduce. However, if this is a long term situation then you have to factor in the effects of inflation. If inflation (RPIX 2.4% as of June 2020, source www.gov.gg/rpi) is higher than savings account rates (c1%), as is currently the case, then the real ‘buying power’ of your money is going down in value, even if the numbers on your statement are not.
What can I do about investment risk?
So you may need to consider accepting investment risk to negate the effects of inflation risk. Following some simple rules can help you deal with investment risk. Broadly speaking, the greater return you want, the more risk you'll usually have to accept. The more risk you take with your investments, the greater the chance of losing some or all of your initial investment (your capital).
If you're saving over the short-term it's probably wise not to take much capital risk. Therefore, what you are investing for and when you'll need access to your money will have a big impact on what types of investments are right for you.
If you're investing for the long-term you can probably afford to take more risk as your money has more time to recover from any potential market decline. Investing in share-based assets has historically proved to be the best way for generating growth that outstrips inflation and a long-term view will usually help manage volatility.
Willingness is only the start
Your ‘willingness’ to take risk, is only a small part of your full and true risk profile. Take Aunt Flo as an example. Having lived a financially frugal life, she subsequently bequeathed you £100,000 in her Will.
On the same day you buy a charity lottery ticket and are later announced as the 1st prize winner of £100,000! You’re obviously £200,000 richer overnight, but how do you feel about each sum of money? Perhaps you have greater emotional attachment to Aunt Flo’s money than you do the lottery win?
Time is a key factor
Different investment risk profiles can be acceptable for the same person with different goals. If you are saving towards a specific target amount of money for school fees for example, the investment term and time in the market will be shorter than saving for retirement. Therefore, the level of investment risk that can be taken may well be limited as there may not be as much time for the investment value to recover from any downturn in the markets. Whereas the same person saving for their retirement may well be happy to wait a longer duration before access to these funds is required. Therefore giving the investment time to grow and smooth out any bumps, yet still achieve the investment targeted return.
These are examples of how different emotional attachments or life goals can influence contrarian feelings for the same amount of money. This will more than likely influence any future chosen investment risk or strategy should you decide to invest your wealth.
For those that do, careful consideration of three key components are required to assess your true risk profile:
Psychological ‘willingness’ or tolerance to take risk, sometimes called ‘risk attitude’
- Financial ‘ability’ to take risk, or ‘capacity for loss’
- ‘Need’ to take risk, including the need to accept risk to meet an objective, avoid falling short of a goal or having wealth eroded by inflation.
A Financial Adviser will use a risk questionnaire to document your risk profile, but this should only mark the beginning of an open two way conversation about risk between you and your adviser. Only by having a thorough and carefully structured conversation as part of a systematic approach to investment advice, can your adviser understand your true investment risk profile.
So with financial markets having recently seen the greatest shock in a century, followed by a steep but partial recovery, it may be time to review your attitude to risk with your trusted adviser. Aunt Flo would be pleased that you did.
To review your risk profile, or any other aspect of your financial planning please contact me on 700155 or by email [email protected]
Past performance is not a guide to future returns. Please note that the value of your investments can go down as well as up and you could get back less than your original investment.
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