REALLY Understand Risk To Get the RIGHT Return for Your Money
I have regularly written in my articles about understanding how much risk to take to get the best return for your money. In this article I am going to dig a little deeper and explain why you need to REALLY understand risk to get the best return for your money.
In financial parlance risk takes three forms: tolerance to investment risk, perception of investment risk and necessary investment risk. I shall explain each one in turn below.
Tolerance to investment risk.
This is our psychological feelings about investment risk. In other words how comfortable we are with the value of our investments going up and down on a daily basis. This is largely shaped by our personal experience of investing and our knowledge of investment matters.
You may previously have completed an attitude to risk questionnaire which contained statements about your feelings towards investing and about what actions you would take in various investment scenarios to which you agree or disagree on a defined scale. Your answers to these questions place a number on you; typcially between one and ten or one and seven. The higher the number the greater is your tolerance to investment risk. That is to say, you are comfortable with being exposed to volatile investments which can can rise and fall rapidly on a daily basis. The corollary being, the lower the number the less tolerant you are of such investment volatility and the more comfortable your with lower, more certain, returns.
Where you are placed on the scale determines what a suitable mix of assets would be for your portfolio. At the higher end there will be a mix of UK and overseas shares while at the lower end a portfoio will be dominated by cash and fixed interest securities.
Perception of Investment risk
While your psychological risk profile may suggest your tolerance to investment risk how you FEEL about it may differ. We often speak to clients who are more or less comfortable with risk than the questionnaire results suggest. How we perceive risk is therefore an important consideration.
How we feel about risk will also largely be driven by our experiences but also by our nature. We may be very cautious and see risk as having our money anywhere other than the bank (or perhaps having money in the bank) whereas someone else will see risk as going to the roulette table in a casino and putting all of their chips on red or black. Neither is right or wrong per se (though I’m not saying gambling is a prudent financial planning strategy) it is simply how we perceive the potential for loss and what it means to us.
Necessary Investment Risk
Simply being guided about how we feel about risk is not necessarily the correct route to take. Someone who is cautious and wants to have all their money in the bank may fail to reach their investment goal as much as someone who is willing to invest in risky shares.
In other words there is risk in taking no risk. This is because you may be investing too cautiously and so are giving up the opportunity for greater returns that higher risk share portfolios have demonstrated to provide in the long term and in fact, after tax and inflation, the real value of money invested cautiously is likely to fall.
Conversely, if you are taking a high risk approach to investing, your wealth may be hit by a stock market crash shortly before you intend to enjoy the capital and will therefore have to defer the pleasure while capital values are restored. This was a common occurrence with investors’ pension funds who hoped to retire at the point the Credit Crunch hit world markets.
Investment timeframe is therefore an important factor in determine how much risk really needs to be taken. The longer we have to invest the more risk we can, and should, consider taking and, as we approach retirement (or the end point of our investment goal) we reduce risk that we are exposed to so that we preserve the value of our capital.
So, you will see it is important to fully understand what your risk appetite is before establishing any financial plan. There may have to be some compromise between the time-frame of your plan and the risk that you are willing to be exposed to if the two are juxtaposed. Additionally, as I have said many times in this blog, it is imperative to always review the risk that you are taking with your pension and investment funds.
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