How much risk is right for you?

Whether you’re an existing investor or just starting out, you might be confused by all the ‘mumbo jumbo’ jargon about investment risk.

Well, don’t worry, most people, including some advisers, are confused about this stuff too, and for good reason, as you’ll find out here.

You can’t rely on the theory!

What might surprise you is that a lot of investment risk theory is unreliable.

And this, despite the fact that the theory is often dressed up in impressive-sounding mathematical terms, like standard deviations and efficient frontiers

Markets are driven by collective human mood swings which are completely unpredictable.

So, you need to take particular care if you see a statement like this:

‘Our investment process is based on a Nobel Prize-winning theory’ …

And you should be cautious because, when it comes to the theories of stock market pricing, Nobel prizes have been given to people with very different views!

Yes, I know that sounds incredible but it’s true.

So, you need to know which Nobel Prize winner your wealth manager follows – to decide on the value of that.

Now, if you’re intrigued to learn more about all this, try these Insights too.

How two Nobel Prize winners can hold opposing views

How to check if your adviser really understands risk and

Why you need to think one step beyond ‘efficient frontiers’

In the meantime, let’s just stop pretending that we can predict the chance of a big market correction, we can’t.

That much is proven with monotonous regularity as with the crashes of 2000-03 and again in 2008-09.

So, let’s simply focus on what you really need to know – when deciding how much risk to take with your money.

Have you chosen your box?

If you’ve not already chosen your investment box (aka wrapper) for your money, this is the place to start.

The ‘box’ might be a pension plan, an ISA, a simple investment fund, an Investment Bond, or something else.

Getting the right boxes for your savings and investments is critically important.

You need a solid process to select the right boxes for your money, and that’s something I’ll share in a future Insight. So, stay tuned for that.

Keep a close eye on charges

Of course, you’ll also need to keep a close eye on the total level of charges you pay (for your investment box, for the funds inside it and for any advice that surrounds it) because these charges can (in some cases) add up to so much as to make the risk of investing a complete waste of time!

Learn more about the issue of overcharging here

Check if you’re wasting £ thousands on charges here.

Focus on four factors

Then, once you’ve settled on a fair value investment or pension wrapper (and before you get into the grisly detail of fund choice) you need to consider these four factors to decide, in broad terms:

how much investment risk

you want to take,

on each of your financial life goals.

You need to consider:

1. What investment risk you need to take, to achieve each of your financial goals – and if your goals are unrealistic, how you’ll adjust them.
2. Your general attitude to investment risk – sometimes called your risk tolerance.
3. Your capacity for investment risk, on each of your goals.
4. Whether your chosen investment assets (Shares, Bonds, Property for example) are especially expensive, or cheap, compared to long-term average ‘value’ measures. (more on those here)

It’s essential to pay close attention to all four points.

If you use a financial adviser/wealth manager (which I’d encourage if you can afford their fees) check that your adviser is considering all four of these points too.

Sadly, not all of them do, and if they’re permanently optimistic about the prospects for investment returns, get a second opinion.

It’s easy enough to find commentaries from other, less ‘bullish’ experts, some of whom you’ll find mentioned in this Insight on the need for balanced Investment views. 

Also, pay particular attention to the third point in that list – your capacity for investment risk – as this will often reveal a need to take a different investment approach on each of your financial life goals.

Tailoring your investment risk to each of your goals?

If you’re not familiar with this concept, it might sound like an odd idea, but it’s the best way to approach your financial planning, and here’s why.

Let’s assume you have a lump sum of money that you’ll absolutely need to be available (e.g. to help a child through college) in 6 years’ time – and you don’t have other funds to call upon, if the value of this lump sum, crashes in value.

In this case, the chances are that you’ll want to invest this lump sum in a low-risk way to ensure its value is protected over time.

By contrast, you might consider choosing a much higher risk / potentially higher return fund for your regular, monthly investments into your pension, if you’ve just started saving into it and you’re not going to need those funds for another 20 or 30 years.

Indeed, you might even view any near term market crashes as good news – because your future investments will then buy in at lower prices.

So, taking account of your capacity for risk can help you financially in two ways:

First, it will help you consider the need to protect your capital on shorter-term and lump sum investments.

Second, it might persuade you that it might be OK to go for higher returns on your longer-term, regular investments. And that could significantly reduce the cost of achieving your goals 🙂

You can learn more on all these issues in my book, ‘Who misleads you about money?’ 

Thanks for dropping in

Paul

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