What do we mean by investment “risk”?

Investment “risk” is a term that is used more widely than it is understood.

A common-sense definition of the word would, for most people, be the chance that they might lose money. In investment terms, however, it usually refers to volatility – how much an asset may be expected to fall or rise in value over a given period, often with reference to the performance of other investments.

Of course, some investments do carry the possibility of total, or near-total, loss of investors’ money. An example of this would be investing everything in the shares of a single company, whether quoted on a stock market or otherwise.

Benefits of diversity

The vast majority of investments made by financial planners on behalf of their clients, though, are carried out using well-diversified collective investment funds that each invest in a basket of assets. A client who is invested in “the stock market” could, by using collectives, easily have holdings in hundreds of different companies.

Of course, stock markets crash, companies go bust and individual fund managers underperform the market. However, markets also come back, other companies do well, and other fund managers outperform.

Past performance is no guide to the future but it is not unreasonable to say that, on the whole, investment in a well-diversified basket of collective funds may be volatile but its “riskiness” mostly depends on when you need the money.

Volatility matters

Generally speaking, when considering long-term investment, a “riskier” fund may be expected to progress to a higher point than a less risky one, but the graph plotting its rise will be more of a zig-zag than a straight line.

If you have the flexibility to wait until that zig-zag works in your favour then higher-volatility funds may be the best choice for you. If, however, you need to make regular withdrawals from your capital then something smoother, albeit with less possibility of “shoot the lights out” performance, will be more appropriate because if you take money out of a fund that has fallen sharply in value then, clearly, there will be less money there to grow again when market conditions improve.

To ensure our clients enjoy the best, and most appropriate, balance of volatility and performance we use a number of tools and processes to build up their risk profiles. First, of course, we ask about their attitude to risk, but then we also look scientifically at their capacity to withstand volatility and their need for performance.

A lifelong cash flow forecast is particularly useful a this stage. Not only can it sometimes demonstrate that clients can afford to take more investment risk than they thought, it also often shows that they don’t actually need to take as much risk as they thought they did because their assets are already adequate to meet their needs.

In investment the crucial thing is to hold assets that are appropriate to your circumstances, needs and aspirations. A properly constructed lifelong financial plan lies at the very heart of understanding what these are and using this information to develop the most suitable portfolio.

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