All investments carry a degree of risk, even cash. The key is to understand these risks and to take steps to address them – not to avoid risk altogether.
Below, we look at the main types of investment risk and offer some tips for balancing risk and reward.
Asset Classes and Risk
There are four main asset classes, all with their own risk and reward profiles:
- Cash is the most stable asset class, which means you are unlikely to lose money. However, it doesn’t offer much in the way of growth potential, and your returns are likely to be eroded by inflation. There is a small risk that the bank could fail, although up to £85,000 (£170,000 for a joint account) is protected by the Financial Services Compensation Scheme (FSCS).
- Bonds are effectively loans to companies or governments which pay a fixed amount of interest. Rewards tend to be modest, and the main risk is that the borrower could default. Prices are stable in most market conditions, but bonds are highly sensitive to inflation and interest rate fluctuations. Prices (and therefore values) can become volatile, so they should not be regarded as a low-risk option.
- Property offers more growth potential, as well as an income stream from the rental. Property prices can be volatile in certain market conditions, but the main risk is liquidity. When property becomes difficult to sell, prices will drop. If you invest through a property fund, there is a chance the fund manager will suspend withdrawals during periods of high demand.
- Equities are shares in a company. These are traded daily, and prices can fluctuate quickly. Equities offer the highest long-term growth potential, but they are also likely to be more volatile in the short term.
There is also variation within each asset class depending on the location and type of asset you invest in. For example, shares in a well-established FTSE 100 or S&P 500 company are likely to be less volatile than a small company in an emerging economy.
Investing for Your Risk Profile
The optimum asset allocation will depend on what you want to achieve and how much risk you can cope with. Your risk profile takes into account:
- Your emotional tolerance for risk
- The returns you require to achieve your goals
- Your investment timescale
- How much you could afford to lose in the short-term without affecting your lifestyle
If you have a long investment timescale and can deal with volatility (both emotionally and practically) a portfolio holding mostly equities is probably the solution. If you need the money within ten years or you want to take a more balanced approach, mixing in some bonds, property, and cash is probably a good idea. If you plan to use the money within five years, volatility is more of a concern than inflation, and keeping the money in cash is likely to be the best option.
Benefits of Diversification
Each asset class behaves differently depending on the market conditions. Economic cycles move in predictable patterns, but we can’t foresee how events will unfold, or how individual stocks will be affected. Some risks (for example, high inflation) will affect all asset classes, while others (for example, financial mismanagement) might be limited to a particular company.
The key is to diversify your assets. If you invest across the market, in a range of asset classes, world regions, and company types, you avoid concentrating too much risk in one area. You will benefit from the overall growth in the market, while smoothing out some of the risk.
Mistakes to Avoid
Even with a diversified portfolio, invested at an appropriate risk level, you can expect an element of volatility. It’s important to accept that this is simply a feature of investing, and reflects how the market works. If there were no low points, we would not see the high points that drive investment growth.
Some mistakes that could derail your investment plan are:
- Trying to time the market to buy low and sell high. We can’t predict the market, and any useful information that could affect performance is already priced in.
- Buying shares based on advertising or investment tips. This can increase concentration risk. Additionally, prices can become artificially inflated due to high demand, which risks significant losses when prices are corrected.
- Investing based on emotion. It can be tempting to buy more when things are going well, or to sell your investments when the market takes a downturn. It’s very difficult to time this correctly and there is a strong chance it will throw your portfolio off-balance. If you sell at a low point, it is likely that you will also miss out on the recovery.
- Investing at the wrong risk profile. If you take too much risk, you might lose more money than you are comfortable with. Not enough, and your returns could be eroded by inflation.
Tips for a Successful Investment Plan
- Invest appropriately for your risk profile.
- Hold a diverse range of assets.
- Control what you can – investment costs and taxation can eat into your returns. A sensible investment plan will aim to keep costs at a sensible level and reduce tax where possible.
- Avoid trying to time the market or making emotional investment decisions.
- Remember that time in the market is the main factor that will smooth out risk and build long-term growth.
Please don’t hesitate to contact a member of the team if you would like to find out more about your investment options.
