Investment Risk – What are the Key Considerations?

Posted: 11th July 2024 Key

Investments are a key part of most people’s long term financial plan. In order to meet your financial goals and objectives, your investments need time and dedicated management to grow.

There are many factors involved in achieving good long-term investment returns. We believe the most important ones are:

  • Careful research and selection of good quality, robust investments
  • Only investing in areas that look reasonably valued at the time of purchase
  • Move out of investments that have become expensive
  • As far as possible, avoiding investments that can suffer a permanent loss of capital (as distinct from a temporary decline in market value)
  • Avoiding investment fads and fashions, which tend to be expensive and often lead to significant losses (e.g. technology in the late 1990s)
  • Ignoring short term market and media ‘noise’
  • Accept that price volatility is inevitable. It may provide opportunities to buy good investments at low prices.

We try to apply all of these principles in managing your investments. However, even with careful management, most investments that have the potential to produce decent long-term returns also carry potential risks. For this reason, perhaps the most important factor of all is your willingness and ability to accept periods of weak performance, and to hold on for better times in the future. That’s why it is critical to properly assess your financial requirements and your understanding, thoughts and feelings about investment risk at the outset, and to keep it under review.

What are the main risks?

Capital Risk: This means that you might not get back as much as you originally invested, or could lose some of the return already achieved.

Income Risk: If you are investing for income, there is a risk that the level of income you actually achieve, will be less than what you had expected. The level of income may vary from one year to the next.

Liquidity Risk: You might not be able to get your money back when you need or want it.  

Risk Profiling

Required risk – the level of risk you need to take

We will discuss your objectives, your current and anticipated income and expenses, and current and anticipated assets and liabilities. From that we can work out roughly what investments return you need to achieve to meet your requirements, which should then indicate what sort of investments would be appropriate.

Capacity for loss – the level of risk you can afford to take

How would you manage financially if a capital loss or reduction in income occurred?

Assessing capacity for loss involves four main considerations:

  • How much income do you need to meet your day-to-day expenditure? Do you have any current or future capital requirements? (such as loan repayments, replacement car, emergency fund etc).
  • How secure is your current income? (this includes your earnings, pensions, or both)
  • What is your investment timescale? The longer the timescale, the more potential risk you can accept, because you have time to wait for investments to recover.
  • How you are investing? If you are making regular investments (e.g. monthly or annual payments to a pension or ISA), then you can generally accept more volatility than for a lump sum investment. If you are regularly taking withdrawals from an investment or pension, then you would usually require less volatility.

Risk tolerance – the level of risk you feel you can take

Unlike required risk and capacity for loss, which are financial calculations, risk tolerance is emotional. It is about how you may feel and react if your investments fall in value, or if returns do not meet your expectations or requirements.

Your investment experience and knowledge of financial products

We will explore your understanding and experience of different types of investment and financial products, and whether the investment or products performed to your expectations. 

Price volatility

The volatility of the price or value of an investment, although important, is not the only aspect of risk.

Commercial and residential property do not usually experience significant short term fluctuations in value, but are nonetheless relatively risky, because they can sometimes fall significantly in value.

Bonds and cash tend to be less volatile, but in the long term may offer little protection against inflation.

For all asset types, any income produced can be automatically re-invested to contribute to the overall return.

The Five Main Asset Types and Their Associated Risks

 

  • Shares (‘equities’)

Shares represent the right to a share in the future profits of a company. Shares can be readily bought and sold through the stock exchange, so their prices can fluctuate considerably. Often movements in share prices reflect short-term optimism or pessimism about the company’s fortunes, or the outlook for their industry or the economy as a whole. Prices may be driven up or down by speculators trying to make quick profits. We take a much longer term view, looking for companies that have the potential to grow their profits over several years.

Shares can provide income in the form of dividends, which are paid out of the profits of the company. Dividends are determined by the company’s management and could increase or decrease. In extreme circumstances the company may decide not to pay a dividend at all.

 

  • Commercial property

Commercial property funds usually own large office, retail or industrial properties, with rental income being a key part of the return. The capital values may rise or fall. Some funds may try to increase the value of their buildings through improvements or changes of use etc.

Unlike shares, property can be difficult and expensive to buy and sell, so prices do not tend to fluctuate very much in the short term. However, it is possible to be ‘locked in’ to a fund if many investors wish to take their money out, because the managers may have to sell buildings to raise the money.

 

  • Government Bonds

A government bond is effectively a loan to the government issuing the bond. In the UK, these are known as ‘gilts’. The holder of the bond is entitled to a fixed payment of interest each year for a given time period. Once issued, bonds can usually be bought and sold. Their prices can change according to a number of factors, including the amount of interest paid, the overall financial position of the country, and other interest rates (e.g. bank interest).

UK government bonds are usually considered to be fairly low risk, because the government is unlikely to default on the interest payments or repayment of the capital at the end of the term. However, the market price of bonds fluctuates, so it is possible to lose money.

 

  • Corporate Bonds (‘fixed interest’)

Corporate bonds are similar to government bonds, but the issuer is a company rather than a country. Like government bonds they can be bought and sold, and their prices are influenced by the same factors. However, the risk of default is usually higher than for government bonds, so corporate bonds should be considered to be riskier than government bonds.

Unlike share dividends, the company is obliged to pay the interest on bonds. If it fails to do so, it will be in default. The company is also expected to repay the face value of the bond at a given point in the future. For these reasons, corporate bonds are generally regarded as lower risk than shares, and their prices tend to be much less volatile. However, the potential returns are lower.

 

  • Cash

Cash is the lowest risk asset class. There is no risk that the capital value will fall, but returns are expected to be low. If the returns are lower than the rate of inflation, you lose value in ‘real’ terms.

Cash can be a sensible part of a long-term investment portfolio if other assets do not look attractive enough to own. It can be invested at any point if better opportunities arise (for example, if share prices have fallen to attractive levels).

Cash might also be in the form of National Savings products such as Income Bonds, Premium Bonds, Index-Linked Certificates, etc.

 

 

The information contained in this article is not a personal recommendation and should not be construed as advice. If you are unsure about the suitability of a particular investment strategy you should speak to an authorised financial adviser. Wise Investments Limited is authorised and regulated by the Financial Conduct Authority, reference number 230553. Registered in England 4970458.

Author

Jo Radcliffe