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A risk worth taking

Summer 2007

Investment performance is inextricably linked to risk and the greater return you require, the more risk you’ll usually have to take. Ascertaining your attitude to risk and how much you can afford to take is one of the most important elements in deciding how best to invest your money.

Risk is a measure of uncertainty and unpredictability, and in the investment world risk is generally defined as the probability that the actual return on an investment will be different from the expected return. Taking very little risk will result in predictable but low potential returns. Investments with a high level of risk can lead to potentially high returns but also, on the downside, the possibility of higher potential losses.

Most people tend to be risk averse and, ultimately, want to achieve the highest possible return with the lowest possible risk. This is known as the risk/return trade off. Investors expect to be rewarded for taking more risk with their money and, as a consequence, the difference between the risk free cash rate and the greater potential reward is often referred to as the risk premium.

At the low risk end of the scale is the risk free rate of return, or what you could get if you placed your money on deposit with an established bank or building society. With a Bank of England base rate at 5.75%, you could earn between 5% and 6% per year, dependent on the amount and term invested, with virtually no risk at all. In contrast though there is the possibility to earn significantly higher returns over the long-term by looking at potentially more risky investments such as equities or alternative investments.

With the stock market currently reflecting very bullish conditions it could be tempting to try your hand at playing the markets yourself but it is an inherently risky strategy unless you are sure of what you are doing. A popular option these days is to opt for an index tracker that will attempt to emulate the performance of a particular market index, such as the FTSE100. This is certainly less risky than picking and choosing individual stocks for yourself, but there is still a significant risk associated with the entire market the index represents. One doesn't have to think back too far to recall market crashes, such as Black Monday in 1987, and the more protracted bear market in 2000 to 2003.

Basically, an investor in the stock market needs to take a long-term view to ride the volatility and price fluctuations associated with the market. This sort of investment is not suitable for someone who may need to sell their stocks at short notice when the share price is low. With a longer time horizon, you have the opportunity to recoup any possible losses and, consequently, can tolerate far more risk.  The minimum period you should be prepared to invest in stock markets is five years. You may, alternatively, consider diversifying your risk by investing in a wider range of asset classes.

When many people consider investment risk they automatically think of losing some or all of their money, but this ‘capital risk’ is not the only type of risk to be faced. The effects of inflation or ‘inflation risk’ must also be considered as rising prices can seriously erode the buying power of your money.  Savings accounts have very little capital risk but inflation can erode the effective return on your investments over time.

So how do you go about determining your own personal risk preference? The answer to this is probably dependent on your financial goals, and these can vary from securing a source of income, to building a substantial lump sum over the longer term to finance specified objectives, such as your retirement. To meet your set objectives you need to weigh up what you can afford to save, what time period you are looking at and, finally, what sort of return is required.

The influence of time frame cannot be underestimated. If the funds are required in the near future a more conservative investment strategy will be required. If the money can be tied up for a longer term, it can usually be invested more aggressively.

Another important influence on your risk tolerance is your net worth - your assets minus your liabilities. This will give you a guide to your available risk capital; the money you can afford to invest without adversely affecting your lifestyle. If you have a high net worth and the proposed investment is a relatively small proportion of your wealth you can obviously afford to take greater risks. Determining how much money you can save in higher risk investments is inevitably linked to how much you can afford to lose. If risk capital is limited it can be dangerous to invest too aggressively and run the risk of having to urgently sell your stocks when the price is down.

Finally, it is important to focus on your financial objectives. If you are building capital with a specific aim, such as a property investment, further education, or your retirement, you will not want to take unnecessary risks with your funds. In contrast, if you are looking to earn additional income and have risk capital or disposable income to invest, then you can afford to be more risk tolerant and take a more aggressive investment approach. 

In attempting to achieve your financial objectives, you will be confronted by a range of different risks that must be managed effectively to achieve the desired outcome. It is therefore vital that your attitude to risk is thoroughly reviewed before building an investment solution. Making informed investment decisions involves not only researching individual investments, but also thoroughly understanding your own financial situation and tolerance to risk.