Your attitude to risk
The decision as to whether an investment is suitable for you must take into account all of your circumstances and objectives. In particular, the timescale for investment, whether the objective is income or growth, and your age. The most difficult is matching the investment to your attitude to risk, and that is what we focus on here.
From the point of view of a private investor “risk” is the possibility of incurring a loss, which is what is feared most.
Here we use the term “risk” to denote the volatility of a fund, that is the extent to which, and speed with which, it might go down as well as up.
This is for two reasons:
- because sharp falls might panic the investor into selling, and thereby realising the loss which they fear most
- because most retail investors are concerned about “the journey”, and want to achieve a given return with the least possible volatility (risk)
So when we look at risk below within each risk bucket we are typically referring to monthly risk. For example the “monthly risk” figure for a typical UK stockmarket fund is about 7.9%. This roughly means that in 19 months out of 20 you should not expect a fall in the capital value of more than 7.9% in any one month.
Far too many investors jump straight into buying investments without considering if risk investments are right for them. One commentator said “Human beings are not cut out to be natural investors”, and this is an uncomfortable truth for many of us. Millions of years of evolution have given us a brain that can instantly process visual images, assess threats, develop language and (sometimes?) make informed choices given sufficient information.
But millions of years of evolution have not enabled the development of the ability to invest rationally. Some say this is because financial markets are a relatively new hunting ground, and given another few hundred thousand years we might do better. Others say it’s because everyone else is buying we want to as well – once in a crowd an ordinarily rational person tends to irrationality (which is why we get investment bubbles).
Human beings not cut out to be natural investors
Whatever the reason, because of our inherent inability to invest rationally, it is vital that we construct (in one of our rational moments) a sound framework within which we deal with risk investments from year to year. For most investors that means having a process to guide you through building a portfolio, and, for the future, the support of a review service like ours - so when the rest of the investment world is losing its head, you don’t lose yours and a large chunk of your investment capital.
Before considering risk in more detail, it is important to remind ourselves that the stockmarket does offer the opportunity for superb long term rewards – the sharp falls in 2008 are not representative of the long term - click here for more details. Even so you must understand that these rewards are available because you take on risk - risk and reward go hand in hand.
So, what degree of risk are you comfortable with?
There is no perfect way to assess this. Asking this question of yourself in a void (without also having some understanding of investment risk and history) is of limited or no value. A sensible way to proceed would be:
- ask yourself questions about your attitude to risk
- inform yourself about investment risk
- understand investment risk attaching to funds
And at the end re-check your answers to 1, as you may feel more or less happy about risk having gone through the whole process, and with the benefit of a greater understanding.
Ask yourself questions about your attitude to risk
Imagine you invested £10,000 just 6 months ago. There is some unexpected news, and the stockmarket, and the value of your fund falls to £7,000, down 30%. How would you feel?
- would it cause you grave concern and worry? Or....
- would you be relatively relaxed, because you are comfortable continuing to take atleast a 5 year view?
Even if you are relatively well off, with secure income, such falls may still give you sleepless nights – how you might react is a very personal matter.
My funds have fallen 30%!”
If this would be a shock you would rather not experience, sell or reduce your risk investments. It might mean you miss out on a continuing recovery – or that you don’t suffer further sharp losses, but that isn’t the point. Whether you should remain invested is about you and your attitudes, not about markets. You need to make a hard-nosed decision about whether you can cope with risk investments, and crystallising losses should be regarded as the price of experience.
The stockmarkets can and do play games with your mind, in particular with the powerful emotions of fear and greed. Some investors may just need assistance to think a little more rationally.
For example, do you have secure income, more than enough on deposit for peace of mind, and no debts? Just re-affirming this will help many stop worrying. But if, despite this high level of personal financial security, you still can’t sleep at night with the possibility of your investments falling sharply, you should sell, whatever you might think about the stockmarket and its potential.
This is a very basic approach to figuring the level of risk with which you are comfortable, and there are more formal approaches for testing your risk tolerance, which would ask questions such as:
- do you think of risk as uncertainty or opportunity?
- are you more concerned about possible gains than possible losses?
- when things have gone wrong financially in the past have you adapted easily or uneasily? have you looked for someone to blame?
What next?
You should now make sure you understand investment risk as well as read about how investment risk relates to funds, before rechecking your answers to the questons about your attitude to risk.
If you would like to go through a more formal risk tolerance test contact us for more details of this service or go to our portfolio builder, where we test your risk tolerance as part of that process - and it only takes 20 seconds.
Once you are comfortable about risk, you can begin to explore the portfolio tools, or, if you have a specific sector in mind, visit our fund analysis tools.