Understanding risk and investment choices

Understanding risk and investment choices


By John Batty, Technical Manager.

Introduction

Since the dawn of time, one investment principle has stayed the same; the higher the return you want on your money, the higher the risk you must take. The casino can double your money on roulette in seconds if you correctly pick red or black, but the risk is you will lose it all just as quickly.

Equally, keeping cash in a safe in Fort Knox could be seen as very low risk. However, inflation erodes the buying power over time.

As an example, someone whose grandfather tucked away in a vault the price of an average house in April 1968 would now have the grand total of £3,595, which would only pay for a garden shed.

If inflation exists, when saving for the long term your savings need to be invested somewhere that allows those savings a chance to grow at the same rate as inflation or better. When considering how we might achieve this, we need to answer two fundamental questions:

  • How long do you have until you need to, or want to, access your savings?
  • What level of risk you are comfortable taking in pursuit of your long term savings goals?

Timescales: how long will you be investing for?

If money is needed in the short term, many investors will chose to take less risk, as short term price fluctuations occur in almost all markets (bar cash and fixed term deposits). However, if money is not needed for 10 years or more (for example), then short term fluctuations don’t have as great an effect as they are smoothed out over time.

Using UK house prices as an example, these have risen over the long term but have experienced a mixture of ups and downs. Generally speaking, the longer an investment is left for, the more the effect of short-term fluctuations is diminished.

Risk: diversification is key

The saying ‘don’t put all your eggs in one basket’ is very relevant to the world of investment. As an example, investing in Apple and Google 20 years ago would have seen great returns. But what if you had chosen one of their early competitors who since went bust? Diversification is very important in spreading risk. This is most commonly achieved using investment funds, which buy a number of different investments, therefore spreading the risk through diversification.

The risk involved in an investment will depend on several factors and the type of investment. Most advisers will recommend a spread of investment funds. While there are hundreds of thousands of different investments, the majority fall into the following three types, with different risks for each.

    1. Funds that buy shares in a company

  • Summary: These investment funds allow you to invest in multiple companies through a single fund, thus giving you diversity through a single investment. You benefit from the profits the collective companies deliver as well as any growth in share price that will collectively affect the price of the investment fund.

  • Things to look for: Is the fund managed by a reputable firm? Has it been trading for long? The historical performance graphs will give you an indication of how it has performed over time. Look at the type of companies the fund is buying e.g. are they major companies listed on a major stock exchange, medium sized companies listed on a minor stock exchange or even small companies that are in private ownership? Is it investing in an industry you are uncomfortable with e.g. arms or fossil fuels? There is a lot of choice out there so take your time and if you are not comfortable, get professional advice.

    2. Buying a physical asset

  • Summary: Some examples would be precious metals, property, land and oil. These investments will go up and down in price depending on demand and supply for the asset.

  • Things to look for: Is the asset something that is easily tradable? Is there a major global market in the asset i.e. is it easy to sell and buy? How volatile is the asset? There are also investment funds that invest in these types of assets.

    3. Lending money

  • Summary: A deposit with a bank is effectively lending the bank money and receiving interest in return. Similarly, money could be lent to a company which wishes to raise capital (known as a corporate bond) or to a government to fund its borrowing (in the UK these are known as Gilts). There are also investment funds that specialise in fixed interest and cash deposits.

  • Things to look for: This area is possibly the one with the closest risk / return correlation. As a government can decide how much money is printed it should always be able to pay back its debt. However, the return on this will reflect this security. Lending to a company will depend on the ability of the company to pay this back and the level of interest received will reflect this. Deposit rates in high street banks will normally vary only slightly between providers and will depend on the timescale the funds are tied up for. However, in the UK (including the Crown Dependencies), they are normally correlated to the Bank of England base rate. In the last 10 years or more this has meant extremely low rates of interest being offered on deposits.

There are, of course, other types of investment which are more specialist in nature such as currency speculation, futures and options and hedge funds which are more for the specialist professional investor. On that basis we will not be covering them here.

Summary: your pension investment

A pension fund is often a person’s largest investable asset and potentially needs to last for that person’s lifetime in retirement (and perhaps also the lifetime of a spouse / partner). This inevitably means long term investments are required. Once in retirement, however, it must be considered that some funds will need to be withdrawn on a regular basis to provide pension income. We call this the decumulation phase and this would normally lead to a change in investment strategy including de-risking as some funds will be taken out over a short timescale.

Everyone is different and has different requirements as well as different attitudes to how much, or how little risk they are prepared to take. This, combined with the wide range of investments available means that taking independent, professional advice from a qualified, regulated financial adviser is always strongly recommended.

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