For many people, investment risk means ‘the chance of losing money’.
But, look a little closer at investment risk and you may view things differently. Investment risk is inseparable from investment reward. Investment risk is actually not only the chance of losing money but also the chance of making money.
Accept no investment risk, and returns will almost certainly be low, possibly even negative in real terms once inflation is taken into account. Take greater risks with your money, and the potential rewards, or investment returns, should be higher.
The risk/reward trade-off
All investments carry risk. Some riskier than others and, for taking on extra risk, they offer the potential of greater returns (or rewards). But, equally, the potential of greater losses. This is the risk/reward trade-off.
Here’s how the four main asset classes of cash, bonds, property and shares appear on the risk/reward spectrum. And whilst past performance isn’t a guide to future returns, historically, this is how each of these broad asset classes has performed.
It’s important to note that within each asset class there are further levels of riskiness. For example, shares (or equities), the highest risk asset class; some stock markets are considered riskier than others. Investing in developed markets like the UK or the US are typically considered less risky than investing in new or emerging markets like India or Brazil. Or within the bonds asset class – lower risk would be UK government bonds, or gilts, whereas high-yield bonds are a higher risk bond option because they deal with companies seen to have a high risk of default and so, to compensate, they offer an attractive reward (high-yield).
How much risk to take?
The level of risk you take will be influenced by your ‘appetite for risk’. Appetite for risk is a very personal thing. What’s risky to one person may not be to another, and your overall outlook on life may well play a part in how much investment risk you’re comfortable in taking, even before we get down to the real financial planning nitty-gritty of things like:
- Your financial goals; Why are you investing? What is the target sum of money you want to achieve?
- How long you’re investing for; When will you need the money?
- How much of your money would you be prepared to lose? And, how much can you afford to lose? (sometimes referred to as ‘your capacity for loss’)
- How much risk do you actually need to take? You may be able to take less risk than you are currently taking if your investment return requirement is low.
Exploring your tolerance to risk and financial goals will help you to select appropriate assets to invest in.
It’s important to be realistic with your financial objectives and risk. For example, prepare to be disappointed if you want to buy a holiday home, in five years’ time, for £100,000, and are investing £50,000 today, in a low risk product to do so.
Equally, understand that if your aim is to fund the purchase of a holiday home in five years’ time, you’ll have to accept a significant amount of risk, and maybe too much risk. In which case, perhaps refining your financial goals and aiming for the holiday home in 10 years’ time is more achievable.
Understanding your attitude to risk
As part of helping you build your financial plan, your 1825 Financial Planner will work with you to ensure your money only takes on the level of investment risk you’re comfortable with. We’ll go through a detailed risk questionnaire which will help you understand your own attitude to risk and how this relates to your own personal financial goals.
For long term investments, accepting risk will give you the opportunity of achieving the level of growth you require. True, the greater the risk, the greater the chance of you losing some or all of your investment but, when you invest over the long-term, there is more time to recover your losses after a fall in the stock market. There are also steps you can take to help manage risk, even when investing in the stock market – see our blog on diversification.
Depending upon personal circumstances and attitude to risk, there may be times where accepting an increased level of risk in losing money could be appropriate for the opportunity of greater returns. And without investment risk, it would be very unlikely you’d be able to achieve anything more than very modest returns on your money. It’s for this reason that, perhaps, risk isn’t such a bad thing. Understood, respected and managed diligently, risk can help you achieve your goals.
If you’ve any queries, please contact your 1825 Financial Planner or, if you’re new to 1825 and would like to find out more about how we can help, please Contact Us.
The information in this blog should not be regarded as financial advice. Please remember that the value of investments can fall as well as rise and you could get back less than you paid in. All information is based on our understanding in June 2020.