A guide to understanding the balance between risk and reward
The following is a guest post about investment risk. If you’re interested in submitting a guest post, please check our guidelines on our contact page.
Successful investment is crucial to your future financial well being and has significant potential for increasing your wealth. However, investing is inherently risky. Most investors accept that they need to take some risk in order to have the best chance of achieving their longer-term goals. Therefore, when developing your investment strategy, it is important to understand the reason for making each investment, your capacity to withstand losses over both the short and longer term, and the extent to which you are prepared to risk such losses in return for the gains you might make.
Financial Management organisations provide an investment approach based around the following key principles:
• Ensuring you have sufficient cash easily available to meet your short-term needs, including allowance for emergencies.
• Taking a clear view of the time frame for which you are able to invest your money.
• Not overlooking the impact that inflation can have on the spending power of your money.
• Spreading investments across a number of different asset classes and investment managers, to reduce the danger of all your investments falling in value at the same time.
To stand the greatest chance of investing successfully and achieving your objectives you need to find the very best managers to look after your investments. These are the key things you should consider when deciding how to invest and when making changes to how your money is currently invested.
This article aims to help you to make sensible investment decisions and provides answers to the following important questions,
• What risks do you face when investing?
• What should you consider when choosing how to invest?
• What types of investments can you choose?
• How do you choose investments that are right for you?
• How do you diversify your investments?
• How can we help you choose your investments?
A fund manager should be able to discuss these questions with you, to help you to understand the level of risk you are comfortable taking for a particular investment. You will then be in a position to discuss which funds and investments are most appropriate for you, taking into account your attitude to risk, your capacity to withstand losses, your objectives for the investment you are making and how long you plan to invest for.
What risks do you face when investing? These risks mean that it is possible you may not get back the full amount of your investment or the real value of your investment may decline. They exist to varying extents in all investments; but, in some cases, one or more of them may be particularly relevant. For example, fluctuations in value may be more pronounced where a concentrated portfolio is held, or where assets are exposed to different currencies, such as shares of companies that operate in other countries, especially if those countries have less developed economies and stock markets.
Choosing not to invest your money also carries risks – in particular, the spending power of money reduces over time due to the effects of inflation. As a rule of thumb, an inflation rate of 5% each year will, over a period of 10 years, reduce the real value of your money by 40%. The key to successful investment is not to avoid risk entirely, but instead to find an appropriate balance of risk and reward to help you meet your investment objectives.
Risks should be seen in the context of the overall time frame for the investment. Some investments may pose a high risk in the short term, leading to initial losses which can nevertheless be reversed by longer-term gains. Conversely – short-term, stable growth may be overcome by an exceptionally high period of inflation leading to erosion of the real value of an investment.
Your investments could fall in value. Almost all types of investment carry the risk that their value could fall, particularly in the short term. This may be due to stock market fluctuations, changes in interest rates or other factors. You may not be able to access your money when you need it Some types of investments can be difficult to sell, or difficult to sell quickly without the value dropping, in which case you may not be able to access your money if you need it quickly. This might not seem to be a risk when you buy the investment, but when markets are under stress, you may find that potential buyers are few and far between. The value of your investments may not keep pace with inflation.
In general, investments that carry little or no risk of falling in value also offer lower potential returns. Thus, whilst the actual value of your investment might not fall, the lower potential return means that over the longer term it will have a greater chance of being eroded by inflation.
You may not be able to afford to withstand a fall in value. It is important you hold cash to meet your short-term needs and only invest money that you can afford to leave for the longer term and see fluctuate in value. In particular, you need to be comfortable that you could withstand any losses if you were forced to sell after a fall in value.
Commercial property Investments.
An investment into a diversified portfolio of commercial property will tend to fluctuate in value less than an investment in equities, but can still fall sharply from time to time. The value of property is generally a matter of a valuer’s opinion until the property is sold. Also, commercial property cannot always be readily sold, so investors may not be able to access their capital quickly. Property tends to generate a higher level of income than cash, making it an attractive investment over the long term for investors seeking income.
Assets which do not fall into any of the previous categories are often referred to as ‘alternative investments’. These include commodities such as gold, oil and timber. For most investors, such assets would form only a small proportion of their overall investments.
Some funds also invest in derivatives. These are contracts issued by investment banks whose values change depending on the value of a range of underlying assets specified in the contract in question. They can be used either to increase a fund’s exposure to certain assets or, as in our UK Absolute Return funds, with the aim of reducing the volatility of returns. Derivatives carry the risk that the institution from which a derivative has been bought might fail to meet its obligations when they fall due, which would impact the value of the investment.
How do you choose investments that are right for you?
Understand that your attitude towards risk is something that you may find difficult to determine. The amount of risk you are prepared to accept is likely to vary over time and may be different for each investment you make, depending on the purpose of the investment. There is a broad spectrum of different approaches, as described below
You are a cautious investor who is reluctant to accept large fluctuations in the value of your capital. However, you understand that no investment is risk-free, and even a lower-risk investment carries a chance that your investment may fall in value.
You want your capital to keep pace with inflation and are comfortable with most of your capital being invested in asset classes such as equities and property, some of it overseas.
You are looking for the potential to achieve higher returns but you accept that this will be at a high risk to capital, particularly in the shorter term. You are likely to have considerable experience of making investments.
Article contributed by James Barnett on behalf of St James Place Wealth Management, an organisation dedicated to providing face-to-face wealth management advice to individuals, trustees and businesses.