Understanding Investment Risk

So what is risk? The most simple definition of investment risk is ‘the potential for the actual return on an investment to be lower than the investor’s expectation.’

So, understanding the level of risk associated with any investments you make is crucial. If you are not comfortable with or do not understand the degree of risk you are taking then you should not invest.

The return from any investment is simply the economic reward paid to you for accepting a certain degree of risk. You would expect the reward paid by a riskier investment to be greater because the possibility of losing money is greater. Your willingness to take a risk therefore, must always be balanced by the chance of a greater payout.

It is your ability and willingness to accept risk that is, by far, the most important factor in determining your long-term investment returns. Despite many of the promises made by certain investment products and funds, it is a fact of life that you cannot have a high return investment without accepting a higher possibility of loss.

It should also be noted that no investment is risk free. Many people opt to leave significant sums in cash under this illusion, totally unaware of the true impact that inflation may have over time. However, this strategy may lead to long-term financial disappointment.

How we measure risk

When discussing risk and return, return is fairly easy to understand – it is the gain or profit produced by an investment. Risk, however is often harder to explain as it is measured by a statistical calculation called ‘standard deviation’. It is ‘standard deviation’ that measures the volatility or the size of fluctuations in returns on an investment. It is this volatility that creates uncertainty.

The relationship between risk and return can be simply summarised as;

  • Low risk – low levels of volatility are associated with lower returns and therefore lower losses
  • High risk – high levels of volatility are associated with potentially higher returns and higher losses

In the long run, asset classes producing typically higher returns are expected to show higher volatility over a period of time i.e. the return in any one year is likely to be significantly higher or lower than less volatile asset classes. Asset classes with lower returns are expected to have lower volatility.

To assess how much risk you are ‘willing’ and ‘able’ to take can be complex, but whilst there are many factors to take into account these can be narrowed down to three primary questions;

  1. How able are you to deal with the ups and downs of investment returns?
  2. How much can you afford to lose?
  3. How much do you expect to gain in order to meet your financial objectives?

Risk tolerance – how much risk are you ‘willing’ to accept?

The role of the first question is to assess your psychological ability to tolerate the ups and downs of investment performance – in other words how much risk are you ‘willing’ to take. Every investor is different and understanding your personal risk tolerance is fundamental to ensuring that you are satisfied with the investment outcomes you experience.

It is important to recognise that the matter of risk tolerance is not primarily an economic concept, but a psychological one. Over 100 years of research into the measurement of psychological differences between people has yielded a clear set of principles that define good practice. This is the field of psychometrics, literally the measurement of the mind. It is the application of these principles that should underpin a risk profiling methodology.

Risk capacity – how much risk are you ‘able’ to take?

The last two questions are down to your own financial circumstances and aspirations.

The second question defines your capacity and tolerance for loss. Whilst you may be willing to take a high level of risk, this has to be balanced by the potential for loss.

No investment recommendation should ever be made that exposes you to greater risk than you can bear without suffering unacceptable financial hardship.

The third question focuses on your short, medium and long-term goals and the need for a required investment return to achieve them. Where you have significant capital already employed to achieve your goals, despite a willingness to take a high level of risk, it is always advisable to take no more risk than is absolutely necessary to achieve each goal along your investment timeline.

If the level of risk inherent within the required portfolio is higher than you wish to tolerate or exposes you to the possibility of unacceptable financial hardship then it will be necessary to prioritise the importance of each desired goal.

It is important to seek professional financial advice to help understand and answer these crucial questions – the output from this process forms the foundation of your personal risk mandate. If you get this wrong your investment journey is almost certain to end in failure or at best considerable stress and aggravation.

Understanding how you answer the above questions is critical. Mapping an accurate asset allocation that will perform within your expected range of risk tolerance and capacity is what differentiates a professional investment portfolio.

The value of investments and any income from them may go down as well as up and you may get back less than the value of your investment.

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