Why is your attitude to risk so important?

When you invest your money the most important issue is your attitude towards risk and capacity for loss. Clearly, no one wishes to lose money, but understandably there is always an increased risk for an additional gain.

The primary measure of risk is the volatility of annual returns for a given asset. For example, a high-risk asset may give good annualised returns over a ten year period, but the value is likely to change dramatically over the short-term in either direction. Conversely, a lower risk asset fund would probably give a much lower annualised return but would not fluctuate as much in the short term.

Unfortunately, you cannot rely on volatility alone and there are some other types of risk to consider:

Attitude to risk - inflation

Inflation risk is the risk that the buying power of your capital decreases over time. A typical example of this would be if you were to invest all your funds into one building society and the net return does not keep pace with the rise in retail prices. This means that in real terms your money is actually losing value.

Attitude to risk - liquidity

Liquidity risk arises when you are not able to cash in your investments. Your funds can become locked in for a period of time or there may be penalties imposed on early surrender. Typical examples are shares which are not traded daily, or when demand is low, such as a property fund where the sale of assets is needed to realise your investment in cash.

Attitude to risk - diversification

In order to reduce risk it is wise to invest in a variety of assets. Diversification allows you to reduce market risk simply by investing in many unrelated instruments, such as shares, fixed interest, property and cash. The age-old saying ‘don’t put all your eggs in one basket’ is key when discussing diversification.

Attitude to risk - specific risks

This type of risk is the most difficult to quantify and should probably be avoided if not understood. An example of this is a complex fund not regulated by the Financial Conduct Authority, or a structured product which is underpinned by a counterparty.

Our risk assessment process

As part of the process of establishing your attitude to risk and determining the suitability of various potential investment risk profiles, it is important to consider what is called your capacity for risk – the degree to which your personal circumstances and opinions will impact the specific investment decisions your adviser recommends.

When you align a risk level to each of your investment goals it helps to consider the following areas:

  • Investment timeframe
  • Debt repayment
  • Capacity for loss
  • Appetite for loss
  • Investment liquidity

In order to assess and manage investment risk we undertake a four-step process. The results of this are demonstrated to our clients in a visual report, which is designed to help you and your professional adviser understand the risk associated with each aspect of your investment, and it enables us to correctly apportion risk to each individual investment or goal.

Attititude to risk diagram for financial planning

Discuss how your attitude to risk and capacity for risk can potentially enhance your financial income in the long-term