One of the most important, and often misunderstood, aspects of financial planning is risk.
The dictionary defines risk as:
‘The possibility of suffering harm or loss; danger’.
When most people think of risk associated with money they think of the negative. This is probably because we are conditioned to think of risk in terms of loss. After all, if someone says something is risky they don’t tend to see the positive side!
However, there can often be a positive side to risk.
When it comes to investing your money, it’s useful to know the different types of risk.
Capital risk: The risk that all or part of your capital, your original investment, will not be returned.
Inflation risk: The concern that your money will lose some of its purchasing power through inflation. Stock-market investments are generally considered among the best ways of addressing inflation risk over the long term.
Interest rate risk: The concern that your money will lose some of its purchasing power through inflation. Stock-market investments are generally considered amongst the best ways of addressing inflation risk over the long term.
Liquidity risk: Since not all investments can be readily converted into cash at their perceived market values, this type of risk can affect the price of shares held in the fund’s portfolio and, as a result, the fund’s unit prices.
Selection risk: This risk is an important consideration for share based funds, and is relevant to all funds. It is a measure of how sensitive a fund’s holdings are to changes in general market conditions. If a fund has high market risk, it may lose value quickly when a market declines, but it may also show the greatest gains when the market rises.
Timing risk: The risk that you try to second guess the stock-market and delay investing thinking that there will be a better time to invest at a different time.
The Positive Side of Risk
No risk, no reward: There is no such thing as a risk-free investment. In order to build assets, you must undertake some type of risk. Greater potential return is the reward for undertaking greater risk. However, taking a large risk does not necessarily ensure a large reward. You must know the risks and consider them against the possible rewards.
Choose appropriate risks: Know and understand the risks involved in various savings and investment vehicles. Make sure you are comfortable with the risk level of the investments you choose.
Manage risk, don’t try to avoid it: Diversify: holding a variety of investments and shares lessens the negative impact of an investment that performs poorly. Invest over time to offset market fluctuations. Monitor your investments to be sure that the risk/reward guidelines you have set have not changed.
Maintain a long-term perspective: Plan to own funds over a long time to help lessen the effects of price fluctuations and market volatility.
The problem with defining risk is that your personal definition will no doubt be based on your experiences, knowledge and perception of what risk is and what it means to you. Only when you sit back and think about what level of risk you are comfortable with will you be able to reach a happy medium.
So how do you go about defining the right level of risk for your situation?
There are tools and questionnaires available in financial planning that are designed to help you along the way. For example, we ask clients to complete a risk profile questionnaire.
This is designed to define:
-What are their needs?
-How much risk are they willing to take?
-What level of return are they expecting?
-What are their personality traits when considering risk and
associated issues?
Once we have this information we apply the results to their financial plans. So, for example, if they need to achieve 10% per annum return to achieve their objectives and their risk profile shows they are comfortable with an investment predicting a 6% return, they’ll need to either lower their expectations or increase the amount of risk they are willing to take or invest more money.
The less risk you take the more likely you are to achieve your objectives, but you’ll need to invest more money to get there. Conversely, if you take a higher level of risk you may be less likely to achieve your objectives, but you may also need to invest a lower amount to reach your goals.
Reaching your goals and objectives is driven by getting the balance between the level of risk you are willing to take and the amount of money you have available to invest.
Evaluating your own level of risk should be a priority, as it’s the first step in making sound investment decisions. Various tools are now being used by forward thinking financial advisers to help their clients with this. Many use
questionnaires that have been designed by specialist risk assessment companies. The Silent Partner and Finanmetrica are two to mention.
If you have ANY money invested in ISAs, pensions etc now is the time to make sure you’re not taking too many risks.
