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Investment Risk… what is it?

Investment risk is probably the most important area of clarification, between a financial planner and client.

I know there are many other areas, which seem important, and they are, I am not reducing their importance, but if there is a single area of potential dissatisfaction for a client, then investment risk is the one!

You see, so many advisers and clients refer to investment risk in relative terms; by that I mean ‘I’m low risk’   Low risk relative to what? ‘I’m medium risk’ Relative to what?

What you define as low risk may be different to what I feel is low risk, and therefore if you ask for low risk and I give you my low risk, we could be in trouble!

That’s why it’s important to define risk in absolute terms, so there is less or hopefully no confusion.

This may have limitations, but it’s my belief that these limitation provide the certainty for a better investment experience.

At my financial planning firm Lexington Wealth, and my online investment platform Lexo.co.uk, we define risk as follows;

  • Low Risk – Cash or cash equivalent
  • Medium Risk – equity based collective investments
  • High – anything not defined above

How’s that for clarity?  I feel, and my clients feel, that’s fairly clear.

Why take risk

It’s important to stop and consider, is risk necessary? I.e. do you have enough money already to last your life, if so why take any risk?  On the flip side, especially in your younger years, the lack of risk can also be risky, because of the long term lack of return, you may need to take more risk than you wish, but over longer time frames (15+ years) this can be acceptable, over the shorter term, unfortunately this is not possible.

Different categories of risk

Until the financial crisis, financial planners and investment advisers only really discussed your ‘risk tolerance’, but the regulator, the FCA, brought to the forefront a new definition of risk, which is ‘capacity for loss’, this significantly improved the discussions with clients and the understanding of investment risk.

The definition of these are;

Investment Risk Tolerance

Your tolerance reflects your desire to accept investment volatility or risk i.e. how much can your portfolio fall before you begin to feel uncomfortable. 

Investment Capacity for Loss

Your capacity for risk is your financial ability to sustain a fall in your portfolio without it effecting your lifestyle.

So your investment risk tolerance could be summarised as your ‘sleep well at night factor’ and your capacity for investment loss could be defined as ‘the amount your portfolio could fall before it effects your lifestyle.’

How do we calculate “Tolerance for Loss”?

We start with the FinaMetrica risk profile, you can complete it yourself at home by clicking here.

  •  This produces a brilliant highly respected report, based on a university established psychometric questionnaire.
  • Then you compare your report results to the available portfolios, or your current portfolio, to find a suitable match.
  • Then, it’s vital there’s a sanity check i.e. you look at the results and the corresponding portfolio and ask yourself, ‘does this feel right?’
  • However, this is stage 1.  Once we have established our risk tolerance, we then need to establish our risk capacity for loss.

How do we calculate “Capacity for Loss”?

This is slightly more difficult without using a cashflow tool, which is how we do this in our planning office.  However, it’s not impossible and a great guide would be that your portfolio would fall by 50% of the stock market allocation and take 10 years to recover.

  • So if you were 60% invested in stock market then you should be expect a 30% fall to be reasonable and take 10 years to recover.
  • If a 30% reduction in your income, or portfolio is too high, then this is too much risk.

Bringing it all together

It’s very common for the tolerance and the capacity for loss to be different and therefore it’s important you make the decision which is right, based on your personal circumstances.

  • I would suggested if you have more than 10 years to access of your money i.e. retirement, then you give your tolerance more weight i.e. you allow that to lead because any falls are unlikely to effect your financial lifestyle.
  • If you have less than 10 years to access of your money i.e. retirement then you allow your capacity to have more weight, this is because you don’t have time on your side to make up the losses.
  • A good rule of thumb I share in my book, The Money Plan, is a process of subtracting your age from 100 and holding this in equities.  So when you are 20 you would hold 80% of your portfolio in equities (100-20), but expect this portfolio to fall by c.40% (50% of 80).  Similarly when you are 75 you would still hold 25% in equities (100-75) and you’d expect this portfolio to fall 12.5% (50% of 25). But remember, this is a rule of thumb!

Summary

There’s no absolute answer, because we’re all human and our emotions are all different.  I will say that the decision you make today, based on a healthy economy and bank balance may be different after a significant stock market fall and redundancy that’s why it’s essential you keep this under regular review.

However the right decision today is the the one which allows you to sleep well at night.

Click here to take the Finametrica risk tolerance test

 
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