Whether you’re investing with a goal in mind, or simply saving for retirement, it’s important to understand risk.
Some people are happy to live with calculated risks if it means the chance of a higher return in the long run. Others don’t want to run the risk of losing money under any circumstances. But being highly risk-averse can have its challenges too.
Investment risk
For many people, investment risk means ‘the chance of losing money’.
But, look a little closer at investment risk and you may view things differently. Investment risk is inseparable from investment reward. Investment risk is actually not only the chance of losing money but also the chance of making money.
If you accept no investment risk, returns will almost certainly be low, possibly even negative in real terms once you take inflation into account. If you take greater risks with your money, the potential rewards, or investment returns, should be higher.
The risk/reward trade-off
All investments carry risk. Some are riskier than others, and for taking on extra risk, they offer the potential of greater returns (or rewards). Equally though, there is the potential for greater losses. This is the risk/reward trade-off.
The illustration shows how the four main asset classes of cash, bonds, property and shares appear on the risk/reward spectrum. And while past performance isn’t a guide to future returns, this is how each of these broad asset classes has historically performed.
It’s important to note that within each asset class there are further levels of riskiness. Shares, or equities, are the highest-risk asset class, and within that, some stock markets are riskier than others. We often view developed markets like the UK or the US, as less risky than new or emerging markets like India or Brazil.
Similarly, there are varying degrees of risk within bonds. UK government bonds, or gilts, would be considered lower risk. High-yield bonds, meanwhile, would be viewed as a higher-risk option because they deal with companies perceived to have a high risk of default. Therefore, to compensate for this, they offer an attractive reward, or a higher yield.
How much risk to take?
Your ‘appetite for risk’ influences the level of risk you take – and appetite for risk is a very personal thing. What is risky to one person may not be to another. Your overall outlook on life may well play a part in how much investment risk you’re comfortable taking. That’s even before we get down to answering some of the following nitty-gritty financial questions.
- What are your financial goals? Why are you investing? What is the target sum of money you want to achieve?
- How long are you investing? When will you need the money?
- How much of your money are you prepared to lose? How much can you afford to lose? This sometimes referred to as your ‘capacity for loss’.
- How much risk do you actually need to take? You may be able to take less risk than you are currently taking if your investment return requirement is low.
Exploring your tolerance to risk and financial goals will help you to select appropriate assets in which to invest.
Grounded in reality
It’s important to be realistic with your financial objectives and risk. For example, prepare for disappointment if you’re aiming to buy a holiday home in five years’ time for £100,000, and are investing £50,000 today, in a low-risk product.
Equally, understand that if your aim is to fund the purchase of a holiday home in five years’ time, you’ll have to accept a significant amount of risk, and maybe too much risk. In which case, perhaps refining your financial goals and aiming for the holiday home in 10 years’ time is more achievable.
The ups and downs
And what about volatility? Lots of people confuse volatility with risk, and it’s important to understand the difference. Volatility is the amount that an investment, shares for example, fluctuates in price – up and down. While it can be true that the greater risk you take, the more likely you experience volatility, it doesn’t necessarily mean you risk making a loss the more volatility you are exposed to. Like risk, volatility swings both ways. And like risk, it is almost unavoidable if you are investing.
Volatility can certainly be nerve-wracking when we see prices fall, but remember, losses are only crystalised when you sell an investment, not while you still hold it. Time can be a healer and this is when the benefits of being a long-term investor are felt; staying invested and staying the course during times of volatility.
Final thoughts …
As with most things in life, there are two sides to every story. So when considering investment risk, it is helpful to remember that it doesn’t just mean potential financial loss. It can also mean reward. Most importantly, recognise the trade-off between losses and gains and understand your own appetite for risk.
Your Aberdeen Standard Capital Client Portfolio Manager can help you determine a suitable risk approach based on your personal circumstances and investment objectives.