By Andy Hearne FPFS
When it comes to investment risk, the word ‘risk’ doesn’t sound particularly appetising. In our heavily-regulated industry, the Financial Conduct Authority (FCA) want to ensure that clients fully understand the investment risks they are taking but the question is; what is investment risk and how exactly does it relate to reward?
The aim with these articles is not to bombard you with technical details and jargon. Instead, I aim to provide a useful overview of the key concepts that should be taken into consideration and discussed with your Independent Financial Adviser.
When it comes to regulated investments that IFAs typically recommend, we’re not talking about risks like gambling on a Roulette Table for double or nothing, nor are we looking at exotic off-shore schemes that may or may not pay off. We are actually talking about investing globally across multiple asset classes, which includes thousands of underlying holdings that are very, very unlikely to all fail simultaneously. (If the global economy did collapse, our money would be worthless anyway, wherever it is held!)
A more appropriate word to use can sometimes be ‘volatility’. In the long-term, Shares will outperform all other asset classes. However, in the short-term it can be a very bumpy ride, so investments in Shares should only be money that you can afford to invest for the long-term (5 years plus). It’s also important to consider including less risky investments within your wider portfolio to strike a suitable balance for you.
It is often misunderstood that Risk and Reward are directly related, in that the more risk you take the more return you will achieve. Although there can be some correlation between the two, it’s not quite this simple. There are varying degrees of risk, some of which are affordable and worth taking, others of which have little/no benefit and could cost you dearly. Part of our job is to separate the noise from the information and then utilise the stuff that might actually be useful to you.
Whether it be ISAs, non-ISA investments or Pensions, there are four main asset classes to invest in:
Cash, which is typically held in Bank or Building Society Accounts, provides a safe shelter for some of your money – i.e. the monetary value will not rise or fall and a small amount of interest could be added on top, year after year. The downside of Cash is the ongoing effects of inflation. As at today, we would expect returns in Cash of around 1.0% pa, but inflation is currently running at around 2.5% – 3.0% pa. This means that the purchasing power of money held in cash reduces in the region of 1.5% – 2.0% pa. In other words, Cash may appear secure, but it is subject to Inflation Risk, which cannot be ignored. We all need to hold some money in Cash to pay our bills, to retain a short-term Emergency Fund and to pay for those one-off expenses outside of our normal expenditure in the short-term. However, beyond this, we should all be seeking better returns elsewhere with money that we can afford to invest for the long-term.
Bonds are simply loans to Governments or Companies. The Government or Company pays a fixed rate of interest on the loan and repays the balance of the loan in full at the end of the term. Bonds provide slightly improved returns over Cash, but the money can be tied-up and relies upon the solvency of the issuer of the Bond. Bonds can be utilised as a useful dampener to risk within a wider investment portfolio, but there are varying degrees of risk with Bonds themselves. For example, Short-Dated Bonds would represent lower risk than Bonds with a long duration. Likewise, Government-backed Bonds (such as UK Gilts) would represent lower risk than Corporate-Grade Bonds, which would be more likely to default on their liabilities. Care should be taken to understand these varying risks before investing accordingly.
Property investments can either be Residential (e.g. Buy to Let) or Commercial. Typically, IFAs recommend Commercial Property as part of a wider investment portfolio for a number of reasons. Property can benefit from rises in Capital Value as well as income in the form of Rental Yields.
Shares (or Equities) are investments in Companies. Shares that are listed on a Stock Exchange and held in investment funds, rather than individual holdings, help to keep costs low and reduces administration as well as spreading investment risk (diversification). Shares can benefit from rises in Capital Value as well as income in the form of Dividends. Over the long-term, Shares tend to outperform all other Asset Classes, but in the short-term are more volatile.
It’s really important to strike the right balance of the above Asset Classes to suit your needs and preferences. This mix is known as the Asset Allocation (i.e. the proportions allocated to each Asset Class). Asset Allocation directly affects both the risks and the rewards you can expect and will receive.
Historically, some Financial Advisers would have asked their clients whether they want Top, Middle or Bottom in terms of the investment risk they could take. This was unsatisfactory for many reasons, so the Regulators helped to introduce Risk Questionnaires for clients to complete which explored investment risk in more depth. However, these typically focused on emotions alone, rather than the implications on the actual numbers and how it all fits in with the client’s overall goals and objectives.
When we discuss investment risk with our clients, we explore three key areas:
• Risk Tolerance
• Risk Capacity
• Risk Required
Risk Tolerance is simply your emotional comfort zone for investment risk. This is intended to be a measure of what level of risk you can emotionally tolerate, without causing you any sleepless nights.
Risk Capacity is how much loss your finances could withstand whilst still being able to achieve your goals and objectives. This can be a complex area and ideally requires a Lifetime Cashflow to fully assess. This can be extremely useful to highlight the strengths and weaknesses in a client’s Financial Plan – for example, if there is a market crash in excess of XX% in the first 3 years. Alternative options can be modelled to explore different scenarios to help minimise the effect of potential crashes.
Risk Required is about how much growth or return you actually need to realistically achieve your goals and objectives and, in turn, how much risk would need to be taken to help achieve that level of return. As an example, if a client needed 3.5% pa net return on their investments to achieve all of their objectives, this return could not currently be achieved in a Bank or Building Society Account, but also why strive for a greater return than 3.5% pa (with increased risks) unless it is absolutely necessary?
After exploring all three areas with our clients, we can then decide upon which of the three is the main priority (if any) or whether a balance of the three outcomes would be most suitable.
Once we have agreed upon a suitable Risk Profile with you, we will then recommend a suitable Asset Allocation for your investments and pensions that achieves the right blend of the above Asset Classes for you. In simple terms, the higher the Risk Profile, the more Shares and the lower the risk profile, the more Bonds. You can also have every blend in between – the range of performance could appear similar to something like this over the long-term:
Graph showing the range of Cumulative Performance from different blends of Asset Allocation over a 5-year period
In summary, investment risk at its core is relatively simple, but it’s extremely important to invest the time to marry your overall goals and objectives with a suitable investment strategy and Risk Profile. This is where we come in.
If you’d like to review your Risk Profile or discuss your investments and pensions with us, please get in touch.
Past performance is not a reliable indicator of future performance. The value of investments and income from them may go down. You may not get back the original amount invested.