Managing investment risk

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Money that may be needed in a specific short term time frame is usually held as cash deposits. The worry that cash may not keep pace with inflation is of less concern as the money is, in effect, an immediately accessible reserve. However, if your time frame extends beyond the immediate to say three years or more, it can be well worth consulting an Independent Financial Adviser -IFA to see what opportunities may be available to achieve returns that exceed inflation.

For many the idea of risking savings in the stock market can be a cause for concern. It may be tempting simply to leave your money on deposit.  Every investing decision you take – including staying out of the market altogether – carries risk. The key is understanding which risks you can afford to take, and which you should avoid.

Let us look at the main types of risk.

Opportunity cost and inflation risk

If you keep your money in low-risk, low-return assets, there are two big risks. First, you sacrifice the returns you could be making if you had invested elsewhere. Worse still, your wealth could be eaten up by inflation. For example, if you try hard, you might get a return of around 2% on cash savings today. But prices (measured by the retail prices index) are currently rising at around 3% a year. So after a year, your savings will buy you fewer goods and services. They’ve lost value in ‘real’ terms and we have not even factored in the impact of taxation which can reduce the returns further.

The same is true of the tiny returns on so-called ‘risk-free’ investments such as UK government bonds (or ‘gilts’). The government is unlikely to go bust: it will always be able to pay you back, even if it has to print the currency to do so. But with bond yields well below inflation, every day you hold gilts, you risk losing money in ‘real’ terms.

Liquidity risk

Timing matters in investing. If you are close to retirement, for example, you should focus not just on the return on your money, but also the return of your money. In short, you need liquidity – the ability to get out of a position quickly, at minimal risk of loss. Some assets are far more liquid than others. Big blue-chips can be bought and sold on the market easily and at low cost, even in the toughest conditions.  Smaller company stocks and bonds aren’t as easy to offload. And buying and selling property takes weeks or months, not seconds.

So, when you look at your portfolio, ask yourself: “How easily can I get out of this asset at short notice? And how likely am I to need to do so?” If you have sufficient ‘liquidity’ elsewhere you can retain investments rather than being a forced seller in a falling market.

Price risk

Asset prices go down as well as up. This may discourage many investors from the likes of equities. So they buy ‘low-risk’ investments. If your financial goal (usually retirement) is a long way off this can be a mistake.  If you have 20 or 30 years to go, you can afford to take lots of risk early on, aiming to earn a decent return.

Also, you should positively welcome falling share prices: the further they fall, and the cheaper they get, the more you can afford to buy.  Indeed when saving for the long term, say in a pension or an ISA, ‘pound cost averaging’ is vital. The key point about pound cost averaging is that you invest small amounts on a regular basis. This means that when prices are high your monthly contribution may buy fewer shares or fund units, but when prices are low your investment buys more shares or fund units.  Buying cheap assets with the potential to offer big long-term returns is the secret to growing your retirement pot.

You can afford to tolerate a bit of price risk in the meantime. The best way to deal with it is to spread your money across different asset classes. For example, inflation is usually bad for bonds (as most pay a fixed income), but it can often be good for shares, as long as the companies you own can raise prices to compensate.  A good IFA will construct a portfolio based on a core asset allocation which he will use as a point of reference to manage the risk associated with individual investments.

Regret

Regret is an emotion of pain and anger when you think that you have taken a bad decision in the past and could have taken one with better outcome. In financial markets we experience regret when we sell an investment and subsequently see the price rise further or we fail to sell an investment that is showing a good profit only for the price to subsequently fall. We look back at what was rather than what is!

Regret is such a powerful negative emotion that the prospect of its future experience may lead some people to make non-rational decisions relative to their present situation.

As with all investing talk to your IFA and explain clearly what you want to achieve and when! Your IFA will then construct investment portfolios appropriate to the risk that you can tolerate to give you the opportunity to be well rewarded and to meet your expectations.

The next time you’re nervous about the risks you are taking… remind yourself which risks you’ve actually got rid of because of those decisions you have made with the help of your Independent Financial Adviser.

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