To some people, risk means excitement. To others it means danger. Across the diverse range of industries, from insurance to investing, from sports to space travel, the higher the risk, the higher the potential reward. We simply need to decide if the rewards we could gain are worth the possibility of losing something.
When we talk about risk as an investment concept, we refer to the likelihood of losing money. We can’t control the financial markets, but we can manage risk by deciding how much to invest in different asset classes.
This decision is not the same for everyone. A client on the verge of retirement is likely to be less accepting of risk than someone in their twenties who is just starting to invest. Even two clients in broadly the same financial situation may have vastly different attitudes and tolerances.
A key step in building a financial portfolio is to establish how you feel about risk. We have prepared a list of questions to help you think about this for yourself. There are a number of risk profiling tools available online, and most of them will ask some variation of these; before assigning a numbered risk profile.
- How much risk have you taken in the past with your financial decisions?
- Would the people closest to you describe you as a risk taker?
- Are you prepared to lose money in the short term if there is a chance of making more money in the longer term?
- How would you feel emotionally if you lost money?
- When you invest money, do you feel more excited about the potential gains or worried about the potential losses?
- Do you believe you need to invest in high risk assets to achieve high returns?
- If you could choose between a low, guaranteed steady return, or the possibility of making higher returns but with no guarantees, which would you choose?
- When you think about financial uncertainty, how do you feel?
- If all of your money was held in a bank account, would you feel safe and secure, or like you were missing out on something more?
- Do you enjoy seeking out exciting opportunities for your money?
Risk tolerance is very personal, and does not always reflect the reality of your situation. Risk tolerance helps us understand how you feel about risk from an emotional perspective. There are a few other factors we would need to take into account before deciding on a suitable portfolio:
Knowledge & Experience
While an inexperienced investor may feel perfectly happy with the concept of risk, the reality may be different if they are seeing their funds lose money for the first time. Certain high risk investments may only be suitable for very experienced investors who can cope with potential high losses. A good adviser would never recommend a complex investment product without taking the time to ensure the client fully understands it.
Capacity for Loss
Again, you may be comfortable with the concept of risk and reward, as well as being an extremely confident and knowledgeable investor. Does this mean that a high risk investment is the best course of action? It depends. Where there is a risk of loss, it’s important to understand how this could affect you from a practical point of view. When considering capacity for loss, the following questions are also relevant:
When is the money required?
If you don’t need the money for another ten years, you have a higher capacity for loss than someone who needs the money now. Even if the funds do dip in value, you have more time for the market to recover.
What other assets do you have?
If the investment in question is a small proportion of your overall wealth, you can afford higher losses than someone who is completely reliant on their fund.
What other sources of income do you have?
If you are still working, own rental properties, or if you have a defined benefit pension scheme, you are less reliant on your fund. You can sustain higher losses than someone without additional income streams.
Do you have any liabilities or dependants?
If you have other priorities for your money, your capacity for loss may be lower than someone without any commitments.
Requirement for Growth
It is also worth considering the amount of risk you actually need to take to achieve your goals. If you can do everything on your bucket list, providing your investments simply keep pace with inflation, do you really want to risk what you have in pursuit of speculative gains? There is no wrong answer here, but it is a necessary conversation.
Alternatively a young, inexperienced investor may need to think about taking higher risks than they are comfortable with to provide the best chance of achieving their goals. Time is on their side, as history has shown that while equities can be volatile, they offer significant growth potential over a long investment term.
Financial planning can be complex, but understanding your goals, objectives, circumstances and feelings can make the whole process easier and more rewarding.