As I have said many times before, investment risk and reward go hand in hand. The greater return and more money you want to make, the higher the risk you need to take.
Looking at this another way, the more investment risk you take, there’s the chance your potential losses could be higher.
So here is what you need to do to ensure you are taking the right amount of risk with your investments.
Before assessing investment risk
Before you get down to the nitty gritty of where you are going to invest your money and how much investment risk you are going to take, you need to do a bit of thinking and planning.
You need to think about the future, where you want to be and what you want to be doing. You need to come up with some goals, targets and objectives.
Here are a couple of examples:
- Retirement – When would you like to retire? How much income do you need in retirement?
- Security – How much do you want to keep as a safety buffer?
- Debt – Do you want to pay off debt and when? Paying a lump sum off your mortgage?
- Legacy – What do you want to leave behind or gift whilst still alive?
It’s very difficult to know the right investment risk level you should be taking if you don’t know what you need the money to do.
Before investing you need to know how much money you need and by when. This doesn’t need to be a fixed sum of cash and a set time. It could be a certain level of income over a certain time period.
Once you are clear on your objectives you should also consider your knowledge and experience of investing.
Look back through the type of saving and investing you have done in the past. Did you understand the product or strategy you used?
Are you clear on the strategy, charging structures and tax implications of the investment you are making?
When it comes to investing, you should never invest in something you don’t understand.
Choosing the right investment risk level
When looking at the right risk level for your objectives you need to consider 3 things:
- Your need to take risk.
- Your attitude to risk.
- Your capacity for risk.
Let’s look at each in a little more detail.
#1 – Your need to take risk
Once you have a clear objective/target in mind for your investment you can work out where you stand and what investment return you need to make to get there.
For example, say you are 55 now and plan to retire at age 65. Your pension is currently worth £250,000 and you have worked out by age 65 you need the value to be £400,000.
We are able to work out that without any further contributions, you need to make around 6.9% per year.
This is very interesting information as:
1) It tells us this person definitely needs to invest as they are unlikely to achieve a 6.9% annual return through cash savings (in the current climate).
2) It also starts to give us an idea of the level of investment risk the person will need to take to achieve it.
Now it could be that the actual return needed is so high and therefore unrealistic it will never be achieved. In this case you would need to re-adjust your objectives. Perhaps delaying retirement for a few years or saving more into your pension.
#2 – Your attitude to risk
Your attitude and deep held character traits are important when it comes to investing. If you are a naturally cautious person then it will likely be too difficult for you to invest at a higher risk level. You will probably feel uncomfortable at the sight of seeing your money drop in value (sometimes quite significantly) as all investment strategies will do at some point.
There is no point investing in something you are not comfortable with as it could mean you end up selling out at the wrong time when markets are down and therefore securing a loss.
You need to be comfortable riding the waves of investment performance.
We use a set of psychometric questions to understand your attitude to risk. These questions get you to put yourself in different scenarios to test how you would react. At the end of the process we get an objective view of how you should be investing.
#3 – Your capacity for risk
So, if we know what investment risk you need to take and know you have the right attitude for that level of risk is it job done?
No. There is one final step.
You may be very clear on the level of investment return you need and you might easily be able to handle the roller coaster of a high risk strategy, but if you can’t afford to take that risk, it’s not the right level for you.
Your capacity for loss is your ability to withstand the reductions in value your investment may see. You need to be sure that losses don’t impact your standard of living.
For example, a 20% drop in your investment value could mean your retirement income falls by £5,000 per year and that this now is not enough to cover all your basic expenditure. This would mean you don’t have capacity for loss at this level.
We are able to test your investment strategy and risk level across tens of thousands of different return and inflations levels to see how likely it is that you can afford to take the risk needed and are comfortable.
So, when it comes to investment risk it is not just about your need, attitude or capacity, it’s a combination of all three and they will intertwine with each other. It’s a case of tweaking the combination until you have a fit you are happy with and that works for your objectives.
Once you know the investment risk level that is right for you, more research will need to be undertaken to understand each investment and fund providers measure of risk, and how it can be mapped to the level you require.
If you would like to understand your current pension and retirement investment risk level please secure a Free Pension Review worth £497.
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.