Understanding Investment Risk & Reward

Risk - An Overview  - Investment risk is a difficult concept to wrestle with.

Most investors tend to view risk as the likelihood of their investments suddenly plummeting in value. What they are concerned about is volatility, the tendency of an investment to vary in price. But if price falls were the only worry, investors could protect themselves by simply using cash deposit accounts.

Another, possibly greater, risk is that an investor’s money will not grow fast enough to meet their needs. For those trying to build up as big a retirement pot as possible, or anyone saving for a specific goal such as a wedding or school fees, this is a very real danger.

THE MAIN TYPES OF FINANCIAL ASSETS

  • Equities
  • Fixed interest securities
  • Property
  • Cash

Each type of financial asset has different characteristics, but only cash and some National Savings products offer capital security. The others all suffer from price volatility to a greater or lesser extent. But history shows over the long term the most volatile type of asset, equities, has provided the best returns.

This is such an important aspect of financial planning and investment planning.  As such we strongly encourage all of our clients to read the Understanding Risk and Reward page.

Investment Analysis & Asset Allocation Analysis of your investments starts with determining three things about your assets:

  • What you have
  • How it works
  • What to expect from them (how they may behave).

Understanding your existing investments is a key to any analysis of your current financial situation. You should have a good understanding of what you have and how your investments work together, before considering any changes to these investments.  Then, when you decide to make changes in your investments, you should consider how the changes will affect your overall portfolio.  This includes determining whether the proposed changes align with your financial objectives and risk tolerances.

The best analysis of your investments is achieved when your entire portfolio is viewed from a carefully structured perspective, which, is what our service provides and our service ensures that any proposed changes to your portfolio will reflect your particular investment philosophy.

How Much to Invest In Each Area - If history was the main guide and in particular longer term history (20 or more years) then equity investment would clearly be the most desirable home for longer term savings and cash would be the least desirable. 

However, it’s not that simple, if it were then the Librarians and Historians would be the richest people in society.  We can never for with any degree of certainty how events will unfold and thus a spread of assets is necessary and this will be determined based on ones individual circumstances.

Financial Crisis of 2008 - If anything focused investors’ minds on risk it must be the financial crisis of 2008.  Queues like those seen outside Northern Rock had not been witnessed for more than 100 years in the UK. When investors start to doubt the actual fabric of a system based on confidence, the world finds itself in big trouble. Suddenly risk and reward came sharply into the investor’s sphere of interest.

Measuring Risk - Risk has objective elements, but it’s also dependent on the attitude of the individual.  One person’s idea of a less risky investment might be another person’s idea of a higher risk investment. Volatility can be measured, but of the various methods, the only relatively accessible one is “standard deviation”, which shows how much the price of an investment varies from its average.

There have been several scandals in recent years, where people who believed they had invested in a “low-risk” investment were shocked to discover it could fall in value.

When financial advisers and commentators use the words low-risk, they generally mean an investment with a record of comparatively low volatility (the up and down movement of an investment, rather than an investment that can result in you loosing all of your capital).  But just because an investment does not usually experience big price fluctuations, does not mean it cannot.

Is there such a thing as a "no risk" investment? Unfortunately not. Even capital guaranteed products can lose money in real terms, as over time capital will be eroded by inflation. In addition, with any product offering guarantees, investors should also question who is providing the guarantees and what level of financial security they enjoy.

Thousands of UK investors in products backed by Lehman Brothers found to their cost recently that a guarantee is only as good as the institution which issues the guarantee.

National Savings & Investments index-linked certificates carry the lowest risk of loss.

Investment Timescale is Key - The amount of time before access to savings is needed is crucial to judging the level of investment risk.  The longer the time frame, the more the danger of poor returns outweighs the risk of loss.

By contrast, those needing access to all of their money within a few years are likely to attach heavy importance to capital security. Someone saving for less than five years should generally stay clear of shares, or any equity-linked investment, as they run a higher risk of getting back less than they invest.

Inflation poses a serious risk, as it erodes both capital and income. In the 1970s, inflation ran at an average of 13% (reaching a horrifying 25% in 1975). Even equities, still the decade’s best performing asset, failed to keep pace, with an average loss after inflation of 2.1% a year. Even with low inflation, defending capital and the spending power of returns should be a priority.