In the context of finance and investing, most individuals have an overly simplistic view of the concept of risk, whereby it relates solely to the notion that an investment may fall in value. A common first step in identifying the right risk profile for any investor is therefore often a discussion regarding the different types of risk to which they might be exposed. Another key aspect of this is the timeframe over which they are investing.
Types of risk
Most people are aware of the basic idea that some assets are inherently more risky than others: for example, cash and gilts are typically low-risk, while commodities and market equities are generally high-risk. You can see more about this in the diagram above.
However, it is not always as straight forward as this. For example, an individual holding entirely cash-based investments might be of the opinion that through this strategy he or she would not be exposing their savings to any risk. Such an approach would leave the investor subject to both inflation and interest rate risk; the risk that inflation will erode the value of their savings in real terms over the long term, and the risk that interest rates will fall or remain low for an extended period.
We have seen both of these factors have a significant impact on investor’s savings over the last few years with interest rates and inflation both very low following the financial crash, and the pound losing value following the Brexit vote. Those investors who have been fortunate enough to have been diversified into other assets such as property and equities over this period have seen positive returns which have more often than not offset the poor returns they might have received on cash.
Having had a prolonged period of strong returns from equity markets over the last eight years, it is easy for investors to become somewhat blasé about the risks involved with equity investment, and to forget that markets do suffer periods of (sometimes considerable) negative returns.
While an investor’s own sentiment towards risk will be key in agreeing an appropriate risk profile, other factors – such as the timeframe for the investment, and the investor’s capacity to accept a given level of risk – will also be important in coming to a decision.
In broad terms, the longer the timeframe available for an investment, the higher the level of risk an investor may be willing to accept. In some circumstances, even relatively cautious investors might need to be encouraged to accept some risk where an investment will be held for the very long term (for example an individual in their 20’s or 30’s investing into a pension arrangement). For an individual investing into a diversified portfolio of assets; the longer the investments are held, the greater the chance of a positive return.
Alternatively, an otherwise aggressive investor might be encouraged to invest in a low-risk portfolio if the monies are going to be required in the shorter term, as this is not going to be appropriate for them given the risk to their capital.
Key questions to ask before investing
- When are you likely to need the money you are investing?
- What are your investment goals (i.e. is it a pension fund, are you looking for on-going income, or is your goal to increase the value of your investments?)
- What is your personal attitude toward taking risks?
- What is your capacity for loss (i.e. how much will it affect you if the value of your investment falls and you make a loss?)
The answers to these quotes will help your adviser to explain the different types of risk which might apply, identify potential pitfalls, and take into account the investment timeframe and your capacity for risk. With this information a Chartered Financial Planner can provide valuable assistance in setting an appropriate risk profile for any portfolio, ultimately maximising the returns for any given level of risk.
It is important to remember that returns from investments are not guaranteed as capital may fall as well as rise, and you may not get back the full amount invested. This article is for information only and does not constitute specific advice. We recommend that you consult a qualified adviser before investing any money.