What does the word “risk” do to you? Does it make you quiver and shiver with excitement? Does it whet your appetite for all the exhilaration of investing? Or does it strike fear into your heart? The fear of all your hard-earned savings dissipating into… nothing. Is risk something to be avoided at all costs? Or do you believe that risk forms an integral part of the investing process?
One of the things we do when we meet is determine your attitude to risk. We need to build up as complete a picture of you and your behavioural tendencies as we can. That includes establishing how serenely you would respond to a significant investment loss, and finding out how you have reacted to market downturns in the past.
This helps us ensure that you take on an appropriate level of investment risk. That level will be reflected in the portfolio that we create for you – a portfolio that ideally you will stick with, throughout the ups and downs of the markets.
Risk tolerance is the amount of risk that you are comfortable taking on or the degree of uncertainty that you can cope with. Nick Rolf is our Director of Private Clients, and his job is to gauge your appetite for risk. Risk means different things for different people. For some, it’s about opportunity and excitement – a shot at winning big. For others it’s about handling the potential for loss – the ability to ride out market volatility and deal with uncertainty about the future.
Obviously loss aversion – believing that the fear of loss can play a more important role in the decision-making process than the anticipation of gains – can affect your entire approach to risk. “Risk tolerance is determined by your how comfortable you are with uncertainty,” says Nick. “You might not actually know what your appetite for risk is until you are faced with a potential loss.”
Your risk capacity is generally independent of your risk tolerance.
“The level of investment risk that you are prepared to take on is determined by your individual circumstances,” says Nick. Your ability to survive the emotional upheaval of risk probably won’t change over the course of your life – it is part and parcel of who you are. But risk capacity is more flexible and will change with your goals (as well as your timeline for achieving them). If you have a mortgage or your own business, if you have children still living at home (with university plans) and if you have parents who depend on you financially… then you will most likely be less willing to ride out a bear market than if you were younger and free of any major financial obligations.
When we determine your risk tolerance, we need to understand your goals – otherwise you run the risk of making a costly mistake. Your time horizon – when you think you will need your money – will significantly influence your relationship with risk.
That time horizon will depend on what the money is intended for, when you think you will need to withdraw it and how long you will need it to last. Goals such as saving to put your children through university or saving for retirement have significantly longer time horizons than saving for a holiday or a house deposit. As a general rule, the longer your time horizon, the more risk you can take on: you would have more time to recover from any potential losses. As you come closer to achieving your goal, it will make sense to rebalance your portfolio, reduce your risk and focus more on preserving what you have – instead of risking major losses at the worst possible time. Generally, this will mean reducing the share of equities in your portfolio from over 70% to around 35%.
An effective way to ensure that your strategy reflects your needs at any given time is to divide your investments up into pots – each with a separate goal. “These pots could be pensions or ISAs, each designed to meet a different requirement – a short-term, medium-term or long-term requirement,” says Nick. And each would have a different level of risk associated with it. A pot invested solely for growth and income, for example, could be invested more “aggressively” than one earmarked as an emergency fund.
We create a picture of your individual risk tolerance when we first meet you, and then ensure that your portfolio’s asset allocation mix accurately reflects it.
Once we know whereabouts on that spectrum you are located, we talk to you about what you can expect from your portfolio. The more you know, the less likely you are to react “emotionally” to any “bumps on the road.”
Traditionally, investments with higher expected returns experience more volatility and tend to be riskier than a more conservative portfolio made up of less volatile investments (like cash and bonds). However, recent months have taught us that even the most conservative portfolio can suffer short-term losses as the markets react and readjust to world events. A diversified portfolio made up of a wide variety of investment options will help mitigate any such losses.
Nick and Chief Investment Officer Peter Lowman carefully consider your relationship with risk, balancing one of IQ’s nine risk-adjusted strategies accordingly. Every time we meet you, we decide whether your portfolio needs to be reviewed, so that you still have the right percentage of global equities, bonds, cash and alternatives to accommodate your investment requirements. In a typical scenario, a high-risk portfolio may well deliver the most growth over a given period, while a low-risk one – despite doing what it purports to do on the tin – may will see the least. And such differences could be measured in significant amounts over the longer term..
Such wide-ranging investment results show how adopting a higher risk strategy can potentially generate far better returns than playing it safe. But high-risk strategies will inevitably put your risk tolerance to the test.