Over the coming months I will be presenting my thoughts about various investments subjects which I hope will enhance your knowledge and help you make informed decisions as a DIY investor. This is not advice; however, with over 20 years in the fund management industry (and recently having joined Willis Owen to head up their research department), I believe I can share my views on a range of investment issues. If there are questions regarding any of the topics I cover you can contact me at firstname.lastname@example.org
or alternatively why not leave a comment on the Willis Owen blog.
Some of the areas I propose to produce more insight about include: ‘establishing your investment goals’, ‘considering risk’ and ‘deciding on asset allocation’. All are key considerations when constructing your investment portfolio and just as important as the final step in the process- selecting your individual funds. To kick off, an essential component of the investment process is understanding investment risk, starting with a general overview before addressing different ways of evaluating risk in further communications over the coming months.
So what is risk? Generally, people tend to think of it as ‘the possibility of losing something of value’ or making decisions that could have a downside as well as an upside. We do this every day of course, many decisions we make on a daily basis, have an element of risk. Not making decisions can also carry risk, for instance deciding to put off retirement planning carries the risk that you will not have enough money at retirement to keep your standard of living at a level you require.
However, this is a narrow definition of the subject and in reality there are often a range of outcomes for a particular situation. The basic concept, in financial terms, to understand is the relationship between risk and reward. The greater the amount of risk you are prepared to take, usually means a greater potential for both loss and gain. Always remember if it sounds too good to be true, it probably is! In the long run investors hope to be rewarded for taking on additional risk with superior returns but obviously there are no guarantees.
At one extreme of the risk spectrum is the possibility of losing all your capital for a small chance of a huge return. Sounds like rash behaviour? Well of course that’s exactly what we do when we play the lottery or place a bet on a horse in the Grand National. But for most of us (hopefully!) the outlay would only be a small part of our total wealth which we wouldn’t lose sleep over. At the other end of the risk scale is cash deposited in a National Savings indexed-linked account- we would be fairly confident the government is not going to go under and it offers some protection against inflation.
Deciding how much we allocate to each type of opportunity along the spectrum of risk will depend on our risk profile and is known as diversification or asset allocation. We will look at this further in a later piece.
Psychologists have identified two separate parts of the brain which process risk and control decision making. One area deals with logical or rational choices and affects our long term decisions. The other drives emotional or irrational behaviour and is more short term in influence. When confronted with worry or perceived risk, some people default to the emotional brain and act irrationally.
To understand customers risk profiles better many financial institutions have used psychometric questionnaires in an attempt to quantify attitude to risk by allocating a score on a scale which reflects an investors’ risk tolerance. This personality profiling can sometimes produce a different outcome to how you perceive your own acceptance of risk. These types of assessments are a good starting point, and can add to your understanding of risk, but they need to be taken in context with your own circumstances and checked to ensure you are comfortable with the outcome. Furthermore, don’t forget that tolerance of risk is likely to change over time with your age and personal circumstances.
We can see that an individual investor is inclined to consider risk from a personal point of view but it is also important to think about the purpose and the timescale of your investment. For example, if you are saving for a specific target where the cost is relatively fixed such as school fees then you may opt for a lower risk investment. On the other hand, if you are saving for a more general purpose such as a holiday to celebrate a special occasion you may be prepared to take on more risk to potentially achieve higher returns. Similarly, if you require a fixed amount of capital to turn into an income for retirement in a few years’ time, you are likely to be more risk-averse than if you are many years away from retirement and relatively commitment- free. Time horizon is particularly important when investing because over the long term your assets will have more time to ride out any market fluctuations.
When determining your own appetite for financial risk you need to consider both risk capacity and risk attitude. Risk capacity is your ability to take risks and is determined mainly by your circumstances and investment goals. Normally, someone with more capital and income and a longer-term outlook will be able to take more risks than someone with fewer resources and a nearer-term outlook. Risk attitude is the willingness to take risks and involves personal preferences. It is more to do with psychology, as mentioned above, than financial circumstances. Some people will be relaxed about taking more risk in exchange for potential high returns while others would rather take a more cautious path. At the end of the day it’s down to what you feel comfortable with and lets you sleep easily at night.