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Managing Risk

 

Your attitude to risk

Attitude to riskWe can do a great deal to reduce risk, but it is impossible to eliminate it altogether. In any investment plan, it is important to understand the amount of risk you are taking and be sure that you are comfortable with it.

The right level of risk for you depends on both your personal preferences and your situation in terms of your ability to tolerate fluctuations in value of your capital and your capacity for losses.

Reading through the following and explicitly identifying your own attitude to risk will be beneficial whether or not you intend to consult a financial adviser.

Risk Tolerance - the ability to tolerate fluctuations

Over the course of your investment life, the value of your portfolio, whether it be direct investment or through a pension fund, will rise and fall. While we would always rather see our portfolio value rise, all investments will have some periods in which the values will drop. Essentially, your risk tolerance is a measurement of how comfortable you are during the downturns. If the risk you take is within your risk tolerance, then you will be able to maintain your investment strategy through both strong markets and weak ones, giving you the best chance of investment success.

Risk Aversion – the capacity for losses

Your ability to take risk is determined by your circumstances as much as by your preferences. Your level of risk aversion is a measurement of the economic harm you would endure if your portfolio had a sharp decline in value. It represents how much you would have to adjust your goals if your portfolio failed to deliver the returns you hoped for.

Your investment return aims

Every investment choice you make involves a trade off between risk and return and in general, a portfolio of safer investments will have less growth potential than a riskier one.

If two portfolios were equally risky, but one made a higher return possible, then you would probably choose the more rewarding, or efficient portfolio. Finding the most efficient portfolio for your preferences is crucial because, over time, even a modest increase in your rate of return can make a significant difference in the amount you accumulate - as you can see in this table.

Rate of return Initial Investment Balance after 10 years Balance after 20 years
2% £100,000 £121,899 £148,595
3% £100,000 £134,392 £180,611
4% £100,000 £148,024 £219,112
5% £100,000 £162,890 £265,330
6% £100,000 £179,085 £320,714
7% £100,000 £196,715 £386,968
8% £100,000 £215,893 £466,096

To increase the returns you are aiming for – the rate of return objective, you will typically have to take more risk. In other words your return expectations should be in line with the realistic opportunities that you have, given your time horizon and ability to take risk. If your expectations are higher then you must adjust the investment period or your attitude to risk accordingly.

Financial advice and risk

If you are planning to make use of a Financial Advisor to assist you in making your decisions, then one of the key things they will want to establish is your attitude to risk, in order to put forward a strategy that meets your situation. Your attitude to risk may of course vary between investments e.g. you may have a different attitude to risk for your pension investments to that for investing in an annual ISA.

Whatever the situation you should consider your attitude to risk carefully so that you can discuss with the financial advisor accordingly and be prepared for completing their risk assessment questionnaire. If you want to gain an understanding of the type of questions you will be asked (although these will vary by organisation) take a look at www.riskprofiling.com/samples provided by Fina Metrica who are risk tolerance experts and take a look at the UK version 2.0 examples.

Although it's actually designed for financial advisors you might also find the following item on the FCA web site useful:   http://www.fca.org.uk/your-fca/documents/factsheets/fs-019-attitude-to-risk 

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However if you feel that you need some help from a financial advisor, then visit our section on obtaining financial advice, or our page on Laterlife selected services and associated advice.

 

 
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