What is risk?
The Collins Dictionary’s definition of risk is: the possibility of incurring misfortune or loss. The Oxford Dictionary’s definition is not much better: the possibility that something unpleasant or unwelcome will happen. Neither definition looks like a particularly attractive proposition and many people will shy away from risk as a result, so how do we define risk in relation to stock market investing?
Assessing a person’s risk often comes down to that individual’s own experiences.
For example take the following scenario: should I stay in this job I don’t like because it’s secure and I receive a reasonable salary each month, or do I take the offer of a new job that I might enjoy with more pay and better prospects?
A person’s response to this question will often give us an insight to their personality and the level of risk they feel comfortable with. For some people, the thought of moving job will involve anxiety, loss of sleep and will result in the decision to stay in their current job as uncertainly unsettles them. These people will generally have a low risk tolerance.
Other people may look to seize the opportunity of the new job, as they understand the rewards could be greater in making the move. This person is more likely to have a higher tolerance for risk.
When I meet a client for the first time it’s important that I understand their tolerance to risk so I can advise them on an approach that’s right for them.
When we discuss risk, I start by explaining the various asset classes and the associated risks with each. Some people assume that retaining money in a bank account carries no risk, however with inflation currently sitting at 2.9% and many savers struggling to obtain 0.5% on their savings accounts, the spending power of their cash deposits is eroding.
If you want your money to keep pace with inflation you have to be prepared to accept an element of risk. How much risk is something only the individual can decide. As a general rule, the more risk you take, potentially the higher reward you can obtain.
The old saying “don’t put all your eggs in one basket” is very relevant, as it’s important to have a portfolio that diversifies over the various asset classes. You could invest your cash in government gilts, corporate bonds, commercial property and equities. All of these options have the potential to provide returns in excess of cash, however the returns can be variable and you have to be prepared to accept the fact that losses and fluctuations can occur.
Traditionally, equities have been the asset class that has provided the best return over a reasonable time period. As a client’s appetite for greater return increases, it’s likely that exposure to equities in their investment portfolio will also increase. Invariably as the exposure to equities increases so too does risk, and my role as a financial adviser is to ensure that my clients understand this association.
Unfortunately, we cannot predict the future (although life as a financial adviser would be amazing if we could!)
Without my crystal ball, we must look to the past to demonstrate how previous events have affected the stock market, and the subsequent real impact to a client’s portfolio. It’s important that my clients fully understand the risks and feel that they can withstand any short-term fluctuation in the value of their investments, without affecting their standard of living.
Whilst the returns from stock market investing can be significant, we cannot guarantee a smooth ride. If you want the higher returns you must accept that at times the value of your investment may fall as well as rise. If you have a reasonable timeframe for investing, for example five years, you should be able to withstand short term losses and fluctuations. One of my clients summed risk up perfectly: “I guess it’s only a loss on paper unless I need to access my funds right now”.
In summary, risk is individual to us all. You need to be honest with yourself and ascertain whether you are comfortable with the risk or whether you are likely to lose sleep over your decision. Be honest with your financial adviser, as it’s only with the true story that we can help you make the right decisions for you.
The views expressed are those of Thorntons Investments. Although all care is taken to ensure the accuracy of facts, absolute accuracy is not guaranteed. The contents of the article are solely for information purposes and are not intended as investment advice or a recommendation to buy or sell securities. Opinions expressed are subject to change without notice. The value of investments can fall as well as rise and you may not get back the amount you have invested.