Risk is one of the trickiest subjects to discuss in investing.
Investors face many kinds of risk. For those planning their future, the ultimate risk is failing to meet their goals. Addressing this needs a sound investment strategy and solid financial planning.
This is vastly different to what many think risk is. They think it is only the degree to which prices and values go up and down. We call this “Volatility”.
If we were to solely view risk as the ups and downs of prices, equities would be risky, and cash would be king. During the Credit Crunch of 2008-9 equities fell heavily, and cash did not. However, since then cash deposits have lost around a fifth of value when we take inflation into account. What I mean by this is that if you had £1,000 in the bank back in 2008 you could only buy £800 worth of goods with it today. On the other hand, global equities have doubled in value, even if you invested at the height of the market in late 2007.
Is taking risks bad?
Based on the above not at all but we must differentiate between good and bad risks.
We all know risk and return are linked and that we can only expect higher returns by taking higher risks. Good risks are those which offer the expectation of fairly compensating you over the long term for taking them. Bad risks do not. Investing some of your money in a portfolio of equities spread across the globe for a long time should be a good risk to take. The value of the portfolio should increase in value higher than any increases in the cost of the goods you could buy with it over time.
On the other hand, owning shares in one or a small, concentrated pool of companies is more likely to be a bad risk. This is because you have all your eggs in one basket as some of the companies may perform poorly or fail altogether. You may get lucky, but you should not bank on it.
We know bad risks include investing in something which is hard to sell, trying to beat a particular market, trying to jump in and out of markets, paying high portfolio costs, and ultimately being scammed. Although a few may get lucky, bad risks reduce your chances of success. They place your long-term wealth at risk
How much risk should I take on in my portfolio?
A suitable level of risk to take in a portfolio balances your need to achieve your goals and how the falls in value your portfolio will experience from time to time will impact you both emotionally and financially.
The emotional impact that comes with seeing your portfolio fall in value. This can cause us to become less rational with our decision making and take bad risks.
The other is if you need to take money out of your portfolio at times when values are down. Say you had most of your money in a soundly constructed portfolio of equities. If you could only invest for, say five years this might mean such a portfolio is suitable for you. This is because such a portfolio is only likely to perform like you will want it to if you hold it for much longer than this. You could find when you come to cash it in that its value is nowhere near what you need it to be. Another example is relying on a portfolio for income. Taking withdrawals during periods of market turbulence can in some cases massively reduce how long it will last.
One of the most critical areas of financial planning is finding a balance between risk and reward which works for you. Another is ensuring it continues to best reflect your changing circumstances. This should happen before any other investment decisions are made.
