Investment Masterclass – What is risk?

Ian King, Thursday December 5, 2013

Central to all of the discussions that I have with my clients about creating or reviewing their investment strategy is the concept of risk.  However, one of the key challenges for any financial planner is to gain an understanding of what the client understands by the term “risk” and how this relates to them.  Frequently one person’s views are about risk will be completely different from that of another.

So what are the common types of risks associated with any investment strategy?

In many cases the first point of discussion is the potential for the capital value of an investment to decrease.  People often associate an investment which can go down in value as one which is “risky”.  Whilst it would be nice to think of risk in solely such simple terms, doing so can be very dangerous.

Time

Firstly, just considering the potential loss of capital as the only measure of risk, a time factor also needs to be considered. Whilst some investments should never fall in nominal value, for example a bank account, other investments such as a portfolio of shares, frequently will be subject to capital loss.

However, statistics show that if you extend the holding period for such a portfolio the likelihood of facing an absolute capital loss decreases. In other words, your portfolio of shares is more likely to lose money over one week than it would if you held the shares for a year, but yet again the one year holding period would be more likely to see a loss at the end than if you were to hold the portfolio for a decade.  In summary the risk of the investment portfolio decreases with the intended period of ownership.

More than just capital volatility

Risk however is a much more multifaceted concept than just the potential for capital loss.  Frequently I discuss with clients the potential impact that the following risks would have for them:

  • The impact of short to medium term variation in income, rather than capital.
  • The risk that an investment strategy would be unable to buy more goods and services at the projected end of the strategy than if the funds were spent now, i.e. the risk that the strategy does not keep pace with inflation.
  • When taking a regular withdrawal or income from a strategy the risk that the underlying portfolio will not keep pace with the withdrawals, thereby leading to capital erosion.
  • Stock, fund or sector risk – having too much of your money in one particular investment basket – no matter how attractive the basket looks.
  • Balancing the risk of having too much of one’s strategy focussed upon UK centric investments, thereby losing out on those available overseas. Currency exchange rate risk needs to be also considered.
  • The risk that the clients’ vision or intentions for the future changes significantly and as a result the investment strategy is not flexible enough to be updated accordingly.
  • The risk that tax rules or legislation may change and as a result negatively impact upon the return made by the strategy.

This list is by no means exhaustive but I hope this is able to give you an idea of the many dimensions which need to be considered when reviewing the various risks of any investment strategy.

Why this is important

I frequently spend a great deal of time with my clients reviewing with them the widespread risks to their strategy and for good reason. My experience shows that disappointment with investments most often arises from when the underlying investments do not match the clients’ perceived tolerance towards risk.

For those of you who have other planners and advisers I would hope that they too are reviewing some or more of the concepts above with you on a regular basis.  It is tempting for both you and the adviser to use what I call a “tick box” approach to risk appraisal without undertaking any kind of discussion, but I firmly believe that it is time well spent to effectively consider together, client and planner, what degree of risk can and cannot be maintained within an investment strategy.

In my next post I will start to help you to look at investment risk in an alternative way but as always if you have any comments or feedback please leave them below.

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