Financial risk is important to you. In the real world risk warns you of danger, but it’s one of the most misunderstood concepts on the financial markets. Without it, you’d actually find it difficult to protect your money and grow it for the future.
For you, risk is the difference between financial security and stress, reaching your goals and delaying them – or having to abandon them forever. In the investment world, risk is the probability that the return will be different to what has been expected – whether that’s positive or negative.
There is a disconnect between what risk means on a day-to-day basis and what it means on the financial markets, which can lead new investors to making the wrong decisions with their money.
Risk of cash
Many savers think they are avoiding risk by keeping their money in cash, yet by doing this they are exposing their savings to the silent threat of inflation.
Inflation eats into the purchasing power of your money over time. If the returns on your savings aren’t keeping up with inflation, your money is losing real value.
Even though the figure in your savings account or the number of notes under the bed might be the same, you won’t be able to buy as much with it as you could before.
Say you’d put your £20,000 ISA allowance in a cash ISA with a 1% return. After one year you’d have earned £200 just by having your money sat in a cash ISA.
Unfortunately, if inflation had reached the Bank of England’s 2% target – it’s been running well above that for some time – you’d have needed £400 just to retain the value of your initial £20,000.
Fed up with the negligible returns on savings accounts, savvy Brits are turning to the financial markets to make their money work harder for them. But without understanding the dynamic between risk and return, many new investors are missing out on opportunities to maximise their returns.
Risk and return on the financial markets
Risk and return work together on the financial markets – you can’t have one without the other. The more risk you can afford to take with your money, the higher you expect your returns to be – although the further your investments can also fall.
If you’d rather prioritise protecting the value of your money, you’ll have to sacrifice the prospect of big returns.
The risk/return trade-off is the balance between the highest possible return and lowest possible risk and depends on an investor’s time horizon, attitude to risk and ability to replace lost funds.
It’s this trade-off that influences all investment decision-making, from outlining a strategy, picking the right investments and managing your portfolio to reach your goals.
What is risk?
Risk is found everywhere and can affect companies, industries and entire asset classes.
When investing there are two main types of risk, systematic and unsystematic. Where systematic risk refers to the entire market and is also known as volatility, unsystematic risk is attached to the specific investment or industry you invest in and can be managed through diversification.
Geopolitical risk, monetary policy and economic health represent systematic risk because they impact the entire market and managing this risk through diversification is more difficult – so is more often done through hedging.
Equities are seen as the riskier asset class with the potential for the highest returns. Before investing in equities you need to consider the risk associated with your specific investment, as well as wider economic risk, interest rate risk, foreign-exchange risk, geopolitical risk and the impact of taxes.
You’ll also need to consider how fees and charges will impact your returns, as well as the impact of compounding and pound cost averaging.
Bonds are traditionally seen as ‘safer’ investments, with investors taking on less risk but accepting a limit on their potential returns.
Although bonds carry less risk than equities, investors still need to calculate credit risk – the possibility that interest on debt obligations won’t be paid – and country risk – that a country will default as it won’t be able to honour its financial commitments.
Volatility is a popular measure of risk which essentially measures movements in an asset price or index. It essentially means that the price of a security can move dramatically over a short period of time; the higher the volatility, the riskier the asset.
Standard deviation is used by analysts to measure the past volatility of an investment when looking at its annual rate of return. The statistical measurement looks at the dispersion of data from its mean and the larger the standard deviation, the larger the difference between asset prices.
Although a common measure of risk, volatility has its weaknesses – namely that it measures movements in an assets price, not its direction. Value at risk (VaR) offers a different approach, by estimating how much your portfolio could lose over a period of time.
Whilst it definitely won’t guarantee you a return, VaR will give you an accurate indication of returns with 95% accuracy.
There are a number of ways to calculate VaR, including the historical method, variance-covariance method and Monte Carlo simulation. Where the Monte Carlo calculation uses a model of forecast returns to run a number of hypothetical trials from, the historical method organises past returns in ascending order and assumes the past will be repeated.
The variance-covariance method uses an average return and standard deviation to compared the normal distribution curve against actual return data.
Understand your tolerance for risk
Whilst it’s important to measure the risk of investments, you need to understand what level of risk you can afford to take on. How you invest and the makeup of your portfolio should depend on your tolerance for risk, your financial goals and your time frame.
You could find you’re completely risk-averse or live for the adrenalin of equity trading, but most people usually fall somewhere in between when it comes to investing for their future.
Diversifying your investments in line with your risk tolerance means you can manage the risk in your portfolio by spreading your money across asset classes. Short-term fluctuations should be smoothed out by gains made elsewhere in your portfolio.
It’s not always easy knowing what you need to reach your goals, especially if it’s pitted against what you want. It’s important to take the time to get to grips with your personality, financial background and financial goals.
Only when you truly understand these can you build a portfolio that reflects you as an investor. At Moneyfarm, we do this for you, matching you to a portfolio that reflects your investor profile and is built and managed by a team of experts to help you achieve your goals.