Risk, in the context of investments, often refers to the degree to which short term investment returns will deviate from the longer-term average, and is commonly measured in terms of volatility.
It is important to understand the level of risk you are comfortable with. If you take a small amount of risk the expected long-term returns will be low but annual returns will be closer to the long-run average. If you accept a greater level of risk, the expected returns will be higher, but annual returns will fluctuate around the long-run average to a greater extent, which could mean a larger fall in the value of your investment in the short term.
Ask yourself how a short-term capital loss would make you feel. Would you be concerned if you saw the value of your investment drop by 5% in a single year? Can you afford to lose that level of capital in the short term?
The level of risk you take will dictate the type of assets you invest in and the proportions in which they are held within your portfolio.
Broadly speaking, investment funds will concentrate on one (or sometimes more than one) of four major ‘asset classes’: equities (shares), bonds (fixed-interest securities), property, and cash. Each of these asset classes behaves differently and will exhibit different risk and return characteristics. The level of overall risk you wish to take will determine the asset allocation of your portfolio. For example, if you are risk averse you may have a greater allocation to less volatile asset classes such as property and bonds. If you were more adventurous, a greater proportion of your portfolio would be allocated to equities, which are considered higher risk.
If you do decide to invest, it is generally accepted that you should do so across a broad range of assets in a diversified investment portfolio. By investing across all of the major asset classes, as well as gaining a broad exposure geographically, and by incorporating a range of market sectors, you can significantly reduce the volatility (risk) without a proportionate reduction in expected returns.
Any investment solution should be evaluated on a risk-adjusted basis. It is, therefore very important to diversify if you want to be rewarded for the risk that you are prepared to take. In technical language, your portfolio needs to be ‘efficient’.
A further consideration is that of investment strategy. A ‘passive’ fund manager will subscribe to the view that capitalism works, selecting individual securities is futile, and gaining exposure to the broader market in general is sufficient to generate positive returns in the long run.
An ‘active’ manager will work with a team of analysts and researchers with the aim of selecting individual securities that are expected to outperform the market and ‘beat the index’. Active funds are more expensive and few consistently do better than their passive counterparts in the long term.
There is a huge amount of ongoing debate about which strategy is ‘best’, but it comes down to you, your needs, objectives and preferences.
The length of time that you plan to tie your cash up for is also very important. As a rule of thumb, if you expect to need your cash within the next five years, leave it in the bank. If you are looking at a longer period you may wish to consider investing these funds in order to target higher returns. You need to understand the anticipated investment period so you can communicate this to your adviser, who will structure your portfolio accordingly.
Contact Paul Hyland at Wingate Financial Planning on 0188 333 22 62