Understanding your limits with investment risk is key to generating long term returns
Wednesday 27 July Author: Owen Foulkes
Investing, whether through pensions, ISAs or taxable investments is about generating the highest level of return for an acceptable level of risk. This sounds simple but identifying the risk appetite of each individual is far from an exact science but making sure the correct level of risk is chosen is key to the success of any investment strategy.
When people hear the word ‘Risk’ it will often have negative connotations. The risk of crossing the road, the risk of flying, the risk of illness. However, when it comes to investment risk, the word itself means nothing unless it is combined with the ‘return’ generated by the level of risk taken.
With interest rates currently at 1.25% per annum in the UK, this can be considered as the current risk-free rate of return and is the approximate return you can currently expect from assets held in cash. The risk-free rate of return is the minimum and investor should expect to receive, but for those looking for higher returns, an element of investment risk needs to be involved,
Establishing the level of risk you should be taking with your assets should be a collaborative process with your Financial Adviser, and they will have tools to help determine the correct level of risk for you. These tools are based on extensive academic research and are the best way to ensure that the level of risk you take is right for you.
What Goes Up Can Stay Up
One of the most common measures of risk is to look at the volatility of an investment, which looks at how much the value of your portfolio moves around monthly or quarterly.
A low-risk investor is likely to favour a low volatility investment, with steady but lower levels of return. As you go up the risk scale, the investment value is likely to change more frequently and by larger degrees, but the level of return available should be higher over the long term.
Your Financial Adviser is required by their regulator to identify and classify your individual approach to risk and only provide a financial plan that fits with your agreed approach to risk.
Once your plan has been agreed and the investment decisions made, you will then be able to experience the real-world risk and volatility of your chosen investments. You should always ensure you feel comfortable with the volatility you experience within your chosen investments, and if the ups and downs are making you uncomfortable then you should discuss this with your Financial Adviser to ensure a more appropriate selection is made.
Finding The Right Balance
Long-term studies of different asset class returns show a close relationship between return and volatility (risk).
Shares have provided the highest historical returns but are the riskiest while cash and government bonds provide the lowest returns but are more stable.
This risk and return framework can be used your Financial Adviser to guide you when developing a personalised investment plan. Your investment portfolio should contain a mix of the assets listed here, to provide you with a range of exposure to distinct types of markets, risk levels and potential returns.
The Right Return
The key question many investors ask at the start of the process is ‘what level of return can I expect from my investments.’ How much more return might be possible for an adventurous investor compared with other risk types?
Investors willing to accept more variability in annual returns (volatility) and deeper drawdowns (percentage loss from peak to trough) are typically allocated a higher proportion of shares.
Adventurous investors might end up with more capital than cautious investors over a 20-year timeframe. But adventurous types would also need the fortitude to accept the possibility of a bigger annual loss along the way.
Different assets will perform in different ways over different periods of time, and unfortunately there is no way of knowing which investment strategy will perform best in future. The most important aspect is taking a long-term view and investing in a way that makes you feel comfortable.