What you need to know about investment risk and how better understanding risk will help your wealth.
Understanding investment risk – what it really is, how much your finances can tolerate and how much is psychologically comfortable for you – is an absolutely fundamental part of wealth management. Trying to plan for the future is virtually impossible if you don’t understand investment risk and it is one of the most important conversations you will ever have with your financial adviser.
Understanding investment risk – what it really is, how much your finances can tolerate and how much is psychologically comfortable for you – is an absolutely fundamental part of wealth management. Trying to plan for the future is virtually impossible if you don’t understand investment risk and it is one of the most important conversations you will ever have with your financial adviser.
Most people have very negative connotations with “risk”. It makes them think about being conned or falling victim to fraud. Or they may instantly think about losing everything. This is known as capital risk and it is just one of the types of risk to consider. More common is uncertainty – the kind which is all around us every day. Investing in stocks or bonds or any other kind of financial instrument has an inherent risk. This can be very uncomfortable if you can’t get a handle on just what this risk represents, but you will feel much more empowered when you understand how investment risk works. There are many variables at play, however. For instance, when interest rates fluctuate and inflation moves, this alters the risks associated with certain investments. Your wealth manager will be able to illustrate precisely the risks each type of asset class and financial instrument presents as you make your investment decisions.
The simple fact of the matter is that you are likely to need to take on a certain amount of investment risk in order to achieve your financial goals
By being overly cautious, by focusing too much on capital risk, you are unlikely to be making your money work as hard as it could be. Equally, you should only take on a degree of risk which is appropriate for your circumstances and which you feel comfortable with. This is very important and is one of the reasons why wealth managers increasingly use behavioural finance/psychometric assessments to find out how much risk their clients really are comfortable with.
The “risk conversation” will involve your wealth manager teasing out your true attitudes and assessing which investments you need to form a holistic investment strategy. There are a huge variety of investments on offer and each works differently in different scenarios. Your wealth manager will also regularly review your investments to ensure that they remain aligned with your risk profile and objectives. Life events, like getting married, having children, changing jobs or retiring are likely to have a significant impact on your profile and your wealth manager will review your strategy whenever one occurs.
Asset classes and the ladder of risk!
The term “asset class” describes particular types of financial security which display the same characteristics and behave similarly in the markets. Aside from cash, the most familiar asset classes are equities, or shares, and fixed income, also known as bonds. Along with these traditional asset classes are alternatives, which cover investment strategies like hedge funds and private equity, and tangible – often collectible – assets like cars, wine, art and jewellery.
The degree to which asset classes go up and down in value together is known as their correlation. Having uncorrelated assets in your investment portfolio can increase the resilience of your portfolio to adverse market conditions, since everything is less likely to fall at the same time. But each asset class also has its own degree of risk and some are considered safer than others.
Cash can be thought of as the least risky and, as you might expect, provides correspondingly low returns. This means that in a relatively high inflation environment the value of your cash can be eroded over time (which is in itself a form of risk).
Further up the risk scale are bonds or fixed income. This is where you lend money over a fixed term to an “issuer”, which could be a government, a multinational company or a smaller, perhaps less secure business. In exchange you get a regular “coupon” payout like interest.
In terms of the risk of not getting your principal investment back, government bonds are safest, since it is relatively unlikely that a country goes bust (although recent years have made this more of a consideration, of course). Next come corporate bonds – debt issued by companies which are financially strong and fairly unlikely to default. The most risky are “junk” or “high yield” bonds.
Next on the risk ladder is property. This means investing in either residential or commercial property (like shops or offices) in addition to your main residence. Here, real expertise is required as the potential return on property would centre on the rent and the potential for capital gain as the value of the property increases over time. This can fluctuate wildly in response to macroeconomic conditions.
Finally come equities. Stocks and shares are considered to be the most risky asset class due to their unpredictability. There are a whole range of factors to consider here, which your wealth manager will be monitoring. Each region, individual market and sector has its own characteristics and you should be wary of dabbling in areas where you lack experience. Investing in UK firms is considered less risky than investing in the US market, for example, while emerging market stock markets like India or China are considered the most risky as the companies involved are less well known (and often because there is a degree of political risk involved too).
Summary
Private banks handle cash, shares and bonds, as well as more esoteric investments. They can also provide mortgages for property investments and these may be secured against your investment portfolio or business. However, most pure investment managers specialise mostly in shares and bonds.
Whichever asset classes you wish to invest in, you will have to take a pragmatic and careful – but not overly cautious – approach to investment risk. If you seek a greater return you will need to take greater risk with your capital, but with more risk comes a greater chance of losing some or even all of your original investment
If you plan to invest over the longer term then you can consider taking a greater degree of risk than if you have a short-term investment horizon – if you need the money for a specific purpose at a specific time not too far off. Investing for the long term also helps to smooth out the ups and downs, known as volatility, that investing in the riskier asset classes inevitably entails but which some can find unnerving. Your investment manager will be able to explain the ramifications of all your investment decisions in-depth.
