2nd December 2019
Risky business: why better understanding leads to better decisions
By James Peer, Independent Financial Adviser
But risk isn’t just related to investment returns; it’s much more than that.
What is risk?
Risk describes the uncertainty of the returns of any given investment. It’s a reminder of the potential for losing, as well as making, money.
It might not be an inviting concept, but understanding it is fundamental to successful financial planning and investing.
Risk varies from one investment to another and to mitigate risk you’ll often hear advisers talk about diversifying an investment portfolio. To ensure your goals are met you split your investment across a number of asset classes such as: cash, equities, bonds, property and commodities.
What’s your risk tolerance?
Risk tolerance is your own ability to withstand fluctuations in the value of your investments. This is different for everyone.
Risk tolerance goes alongside risk appetite: How much risk an investor is willing to take?
Understanding your own tolerance and risk appetite
This is important as it helps to build an understanding of your attitude towards investing and is a subjective assessment. This, in turn, helps inform the discussion around your overall risk profile. Conversations that help build understanding of risk are important for a number of reasons.
Take the scenario where someone who is risk-averse and has an expectation for outcomes that may not be met by a low risk portfolio. In such scenarios, investors need to consider whether they are prepared to take more risk or reduce their expectations of future returns.
Capacity for loss
To take this one stage further, we refer to ‘capacity for loss’, which is an objective assessment of the risk a client can actually afford to take.
Anybody thinking of investing needs to consider how they would feel about losing part of their investments during times of volatility, or even a ‘market correction’. Would this impact your plans or standard of living?
Of course, prudent planning means having cash available for short term needs and sound investing means that any short term loss should have time to recover when considered against your overall goal.
Trusting your long term portfolio
Having that financial cushion to withstand riskier times comes hand in hand with having the psychological ability to trust that your portfolio is built with risk in mind and this is where understanding your goals is important.
What are your investment goals?
Setting goals is fundamental to understanding what risk you’re willing and able to accept in relation to your investment portfolio.
Clients often have a number of investment goals with different time horizons, in which case risk can be considered separately for each investment.
You may want to:
• Keep up with inflation, thus avoiding cash losing value in a bank account, or
• You may be funding retirement with a need for regular income over 20 years or more.
A lower risk investor may be comfortable with a higher risk portfolio for the achievement of a long term goal, knowing that the extended time frame mitigates the impact of short term volatility.
As with financial planning goals, your risk profile may change so it’s important to have regular reviews with your adviser, helping to ensure your portfolio delivers a successful investment experience.
Finally, such is the importance of understanding risk, any investment comes with the following disclaimer:
‘As with all investing, your capital is at risk. Past performance is not an indicator of future results and future returns are not guaranteed’.
Only through treading a carefully managed pathway can you ensure your goals remain attainable. Of course, risk is built into your financial plan from the outset, so to find out more or discuss your existing risk profile, don’t hesitate to contact us.