There are many different types of risk when it comes to financial planning, however when we talk about risk the majority of the time we are talking about investment risk. So what is investment risk? Investment risk is simply the risk that an investment may decline in value. As we will explain, this in itself doesn’t need to be a problem. There are things that you can do to protect yourself against investment risk and to make sure you are taking the right amount of investment risk in your own portfolio for your own individual circumstances.
Before we get into those, it’s helpful to understand the concept of investment risk and the relationship between risk and return. In theory, the more risk an investment carries the higher the return on that investment should be. The reason? Because you need to be compensated for the additional risk you are taking. If you think about it, if cash in your bank account always paid interest higher than the return of the stock market over a long time period of say 20 years, no one would ever invest in the stock market given the capital value of cash doesn’t reduce compared to the daily ups and downs of the stock market. There has to be some sort of reward for accepting the increased risk that your capital may reduce. If we take the three main asset classes we can see that they have different risk and return profiles:
- •Cash – lowest risk but also the lowest expected return
- •Bonds (sometimes known as fixed interest but they are loans to either governments or companies) – higher risk than cash and a higher expected return
- •Equity (shares in companies) – highest risk, highest expected return You might be thinking that now we know that investing in shares in companies should give us the highest expected return, shouldn’t we just invest everything we have into shares in the stock market and finish the article now? Well, it isn’t quite so simple! Firstly, the theory doesn’t always play out. The return is only expected and if it materialises it is not linear. For example, over the last 10 years, global equity markets (as measured by MSCI ACWI, to 31 July 2023) have returned 11% per annum. However, in only one of those 10 years did they actually return 11%, the returns in the other 9 years ranged from a low of -8% to a high of 29%. This volatility causes us to have to think about how much we want to expose our portfolio to the daily ups and downs of markets.
Everyone has a different level of investment risk they are able to take based on their own circumstances and we can measure this as the risk that your money will decline in value so much that it causes you to make an unwise decision to withdraw. When deciding on how much risk to have in your portfolio, two main factors come into it.
The first is your own attitude to investment risk. There are many people who dislike the value of their investments falling (not that anyone particularly enjoys it!) but crucially they dislike it to the extent that they find it very difficult to keep holding their investments, particularly if stock markets fall over 10% (which is a relatively common occurrence). It’s very common behaviour to sell investments after they have fallen, wait for them to recover and then buy back in. This can really harm investment returns over the long run as some of the best periods to be invested are after stock markets have fallen.
The second is your capacity for investment loss. This effectively means how much you could lose before any loss in value affected your own personal financial circumstances and lifestyle. For example, if you are 25 years old and your pension fell in value by 25%, does it really matter? You can’t access the money for at least 30 years and it is going to have no effect on your ability to live your life right now. In this scenario you would have a high capacity for loss. Alternatively, if you were looking to buy a house imminently and you were relying on your ISA for your house deposit, and your investments in the ISA fell in value by 25%, this would have a material effect on your life and would probably mean you can’t buy the house you wanted. Therefore, you have a low capacity for loss as you don’t have the time horizon to take that risk, regardless of whether you get emotionally bothered about falling stock markets.
Working out how much investment risk you can and should take is not an exact science and it may take a while to figure out. After all, if you are just starting investing and you have never experienced a 20% downturn in markets, you will not know exactly how you will react. There are things you can do to protect yourself however. Firstly, you do not have to invest all your assets into equities. A lot of investors choose to invest in equities and bonds at the same time, a common ‘traditional’ portfolio is 60% equities and 40% bonds (though all variations of this are used!). Bonds are used to provide more security of the portfolio as they tend to perform differently to equities. they tend to return less but also fluctuate in value less, so when equities fall, bonds should soften the blow and make the overall fall in the portfolio less, which is great if it means you are able to see through your investment strategy and makes the falls (when they happen) easier to stomach.
The other thing to do is to make sure your portfolio is diversified. Diversification is making sure that not all your eggs are in one basket. The best way to do this is via an index fund. Throughout this article we have mentioned ‘the stock market’, and by that we mean the return of all the companies in the MSCI ACWI Index, which tracks the return of global stock markets by investing into companies with regard to their size. For example, Apple makes up 4% of the index and therefore 4% of your money is invested in there, while there are a further c2,900 shares in companies that make up the remaining 96%. Therefore, if you invested in the index and Apple has a bad year and performs poorly, the overall effect on your portfolio will be minimised, given there are c2,900 other companies you are invested in. If your whole portfolio was invested in Apple and it performed poorly, the effect on your portfolio would be much more detrimental.
It’s important to only invest money for the long term (at least 5 years) due to the volatility of investments. Once you are sure of that you can decide how much risk you would like to take with those investments (bearing in mind that everybody is different!).
