When it comes to investing, there are many different forms of risk. In order to invest successfully – and sleep well at night – you need to understand them all and how to manage them.
“There is risk involved in everything; investing will mean accepting the unpredictability of returns and could result in a loss and/or gain in portfolio value,” says Angela Murfitt, a chartered financial planner at Fairstone Financial Management. “Even doing nothing and leaving cash in the bank involves risk. Cash deposits are perceived as risk-free investments, but even they are exposed to less obvious risks, such as inflation and the risk of the bank failing.” For more on this read How safe is your bank?
The good news is that if you understand risk and manage it carefully, you can build an investment portfolio that has the best chance of achieving your financial hopes without giving you sleepless nights.
“Investors should take sufficient risk to meet their long-term investment objectives, but they don’t need to take any more,” says Danny Cox, a chartered financial planner at Hargreaves Lansdown.
What risks are you prepared to take?
First, there is market risk, which is neatly summed up by the small print you see on all investment paperwork: “The value of your investments can go down as well as up”.
Investment returns are volatile and your capital can shrink or grow depending on the external factors affecting your investments. For example, share prices rise and fall depending on demand for the share.
“Some investments carry more market risk than others,” says Darius McDermott, managing director at Chelsea Financial Services. “Developed market government bonds are low on the risk scale. There is usually very little risk that the UK government, for example, will default on
its loans. On the other hand, emerging market shares can be very volatile.”
Another issue to be aware of is the effect of currency movements on your investments.
“One risk we are witnessing at the moment is currency risk,” says Mr McDermott. “UK investors in overseas equities have seen their investments rise more than expected since the EU referendum, as sterling has fallen against other currencies. “This can work the other way, though: investments can fall in value if currency works against us, even if the underlying shares are doing well.”
The other risks you need to be aware of are those you create yourself: shortfall risk and longevity risk. The former is the risk that you won’t reach your financial goal, either because you don’t save enough or because you don’t invest in the right asset mix to achieve the growth you need. The latter is the risk that you outlast your retirement savings, that you retire at 65 with enough money to last 20 years but you live to 95, for example.
How do you decide how much risk to take?
“In order to make your money grow through investments, you have to take some risk, but it’s all about knowing how much to take on and ensuring risk is being managed well,” says Jenny Holt, investment expert at Standard Life.
The first step is deciding what you want to achieve with your money. You shouldn’t invest your emergency savings, as you need to be able to access these quickly. You then need to think about how long you want to invest your money for. In general, the longer it will be invested, the more market risk you can take.
“When investing over longer timeframes, even cautious investors could potentially afford to take on more investment risk, as the effect of investment market volatility is reduced over a longer term,” says Ms Murfitt.
“The availability of an emergency fund to draw on if things don’t go immediately to plan protects investors from being forced to cash in investments when markets are lower; they can afford to sit tight until things improve.”
Next, you should assess your investment goals and how much risk you need to take to achieve them.
“For example, an investor looking to double their money over 20 years would need a return after tax and charges of around 3.5%. Working on the basis of portfolio returns of equities [shares] at 6% and bonds at 3%, a portfolio could be made up of 80% bonds and 20% equities, and it would give a return of 3.6% a year,” says Mr Cox.
Will you fret over your portfolio?
You also need to consider your risk tolerance and risk capacity. The former refers to your anxiety levels. You don’t want to invest in assets you will then fret over. The latter refers to your capacity to take a loss. You need to consider how much a loss of, say, 50% would affect your overall financial comfort.
If, after you’ve calculated how much risk you are prepared to take with your investments, you find your current portfolio is too risky, it is fairly simple to reduce your risk. You need to rebalance your portfolio by selling higher-risk assets, such as emerging market equities, and buy lower-risk assets such as corporate bonds.
Working out your attitude to risk isn’t a one-off task; you should re-assess it regularly as your personal circumstances change and your investment goals alter.
For example, as you get nearer to wanting to access your nest egg, you may want to move your money into lower-risk assets to reduce the chance of a last-minute market plunge putting a big dent in your savings.
It is also important to regularly rebalance your portfolio in case outperformance in one asset class leaves you overly exposed to risky assets.
Seek help on assessing your attitude to risk
If you make an appointment with an independent financial adviser (IFA), one of the first things they will do is go through your investment goals, personal circumstances, overall finances and risk tolerance to work out how much risk you should be taking with your investments.They will then help you build an investment portfolio that matches your risk profile.
Alternatively, many online resources can help you work out your risk profile. For example, Standard Life has a free online questionnaire that can help.