“So Chris, we have established what you goals and objectives are for the future.”
“That’s it then” said Chris, “we can get on and invest the money, right?”
“Well, not quite Chris. We need to know how much risk you can tolerate and with how much of the money you have available to invest. Establishing you attitude to risk is like working out what level of risk would keep you awake at night. But just because we can establish what your maximum level of risk is, you may not need to take that amount of risk to achieve your financial goals. It’s just a guide to what you could tolerate.”
This was the first stage financial planning meeting with Chris after I had met him at a party. After being introduced he asked me the usual question that financial advisers get asked.
“Where’s the best place to invest at the moment?” See my previous article here
So if you are planning to make any type of investment, it’s really important to ensure you only invest what you can afford to and you should always keep deposit funds available to cover any immediate term needs. I know interest rates are very low at the moment and it is tempting to invest all of your money, but this really is not advisable. Ideally you should hold between three and twelve months’ income in an immediate access account to cover any unforeseen circumstances.
So, understanding your attitude to risk is really important.
Investments that are higher risk usually have a higher potential for higher returns. However the downside is that any losses are also potentially much greater.
On the flip side, if you security is more important for you, investing in more cautious investments is likely to reduce the chances of a fall in the value. However, when it comes to investing, there are few if any investments that can entirely protect you from a market fall.
If you are unwilling to take any risk with any of your money, investing is not the place for you. The reality is that you should probably hold your money in a deposit account. The downside to this is that inflation will reduce the value of your money over time. The actual money amount may not fall, however what your money can buy, will reduce over time, as prices of goods and services increase.
That said, investing your money will not automatically secure you a ‘real’ return after inflation either. The value of investments can rise and fall over time.
“So there are two things we need to focus on for the moment Chris. Firstly, your willingness to take risk and secondly, your ability to withstand risk.
Let me explain.” Using a series of very specific questions we can begin analyse your attitude to risk. If you like, your own tolerance to the ups and downs that occur in every investment portfolio over time.”
Withstanding a certain level of risk is what we call “capacity for loss”. You may have a certain level of attitude to risk, but your personal financial circumstances may be such that you cannot afford to take that level of risk. This is really important should something go wrong with your investments. For example, the credit crunch of 2008/2009, saw investment values fall dramatically over a relatively short period of time. Not every investor could afford those falls in value.
So what levels of attitude to risk are there? Well, depending on which adviser you talk to they may have anything from 5 to 10 different categories. However in simple terms, they can be broadly classified into four separate categories.
The zero risk investor
Any loss of capital would be intolerable by this type of investor. This means that you are more likely to hold your money on deposit, or in cash ISA’s.
Inflation is more than likely to reduce the real value of your money over time.
The low risk investor
This type of investor wants to achieve reasonable returns, however it is important to preserve as much of the capital should markets fall. The value of this type of investment portfolio can fluctuate, however both the upside and downside potential will be reduced.
The medium risk investor
This type of investor is looking for the opportunity to achieve attractive returns however it is still very important to invest in a way that does not expose all of the capital to more riskier investments. The value of this type of investment portfolio can fluctuate and both the upside and downside potential will be greater than for the low risk investor.
The high risk investor
The high risk investor is usually an experienced investor and is prepared to take on high levels of investment risk that offer the potential to achieve excellent returns. Strong investment returns is the priority. The value of this type of investment portfolio can fluctuate significantly and both the upside and downside potential will be greater than for the low risk investor and the medium risk investor.
Investments can fluctuate in value and you might get back less (or more) than you invested. The value of investments can go up and down.
An extensive discussion with Chris about his attitude to risk and capacity for loss has really helped us formulate an appropriate investment solution to help him achieve his financial goals.
This article does not provide specific advice and you should always seek professional advice from a qualified adviser before making any decisions.
Contact Martin Dodd on 01902 742221
or email him at [email protected] if you would like talk about money issues.
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