Behavioural finance has an increasingly central part in conversations about investment risk, since managing emotional responses plays a key role in maximising returns.
Investing is all about using money to make money, but these returns are always a reward for taking on an element of risk, however small. In reality, there is no such thing as an entirely safe investment and in fact the closer an asset is to being a safe store of value, the smaller returns it generally offers.
Indeed, cash might sometimes feel like the safest way to hold your wealth, yet in reality might be anything but due to the way that its value will be eroded by inflation over time. (This guide details alternative safe havens for your capital beyond cash.) It is also worth mentioning that cash deposits are only ever as safe as the institution holding them and are only covered up to £85,000 for each one you hold money with under the Financial Services Compensation Scheme. This is why many of our users come to us seeking to diversify their cash holdings.
Defending against inflation to maintain the spending power of your wealth – and hopefully generating healthy returns over and above this – therefore calls for you to take on at least a modest amount of investment risk. Understanding how much risk you can afford to take on, what level of risk you will feel comfortable with psychologically and the amount that is necessary to achieve your financial goals is key to a sound investment plan.
Accurately aligning these parameters with your investment portfolio is also a regulatory requirement, so assessing your risk-profile will figure highly in all your conversations with wealth managers, both at the outset and on an ongoing basis. Your risk-profile, like your wealth management needs generally, is likely to evolve significantly as your circumstances and goals change. As such, reassessing your risk-profile periodically to ensure investment portfolios remain suitable is a key duty imposed by the regulator.
Risk-profiling is a formal assessment which typically centres around a questionnaire, but you should also bear in mind that the discussions and graphical illustrations used during this process are highly useful exercises in themselves.
Online-only platforms may rely solely on self-assessments, but the wealth managers we represent recognise the complexities the question of risk can throw up, and so generally use these tests merely as a starting point for validation and further exploration. Many online tests are now very sophisticated, but there is great value in an experienced wealth manager’s skill in drawing out a person’s true attitudes and expectations. Our users often tell us these discussions were a highly revealing exercise.
Making an accurate assessment of an investor’s risk-profile is as much an art as it is a science, and wealth managers’ techniques may vary quite significantly. Generally, however, they will be looking at a few key areas.
It goes without saying that your attitude to risk is inextricably bound up with your capacity to absorb potential losses – meaning the extent to which any losses will negatively impact your standard of living, and how long you could withstand this detriment for. This is a tricky question, but can be usefully thought of in terms of the minimum income you (and your family) need to sustain your desired lifestyle.
Capacity for loss is really the first question to be tackled, as those with low to no capacity shouldn’t really be taking on any investment risk at all – despite what their appetite for risk might be.
Also known as “risk attitude”, your appetite for risk describes how much investment risk you can tolerate psychologically. Ensuring that you have a comfortable investment journey is actually a significant part of what wealth managers are seeking to do when they devise your investment plan. For example, if a lot of volatility (your investments going up and down in value often) would bother you, then your adviser would look to deploy sophisticated strategies to smooth these fluctuations.
It is vital, however, that you have a realistic attitude towards the amount of risk you must necessarily take on to achieve your financial goals. It is common for investors to say they do not wish to assume any risk at all. Yet in order for your savings to retain their spending power over time they must at least keep pace with inflation – and securing that reward will entail some degree of risk.
Some types of investment are only open to investors with a certain amount of wealth and experience of investing. However, your level of investment experience and knowledge of how markets and financial instruments work will also feed into your risk assessment generally.
Experienced investors will have been through both bull and bear markets, and so will not be alarmed by periodic stock-market corrections, knowing that any temporary losses are likely to be more than regained over time. Likewise, experienced hedge fund investors will know that they are chasing higher returns by taking on heightened risks.
Your adviser will put a lot of effort into understanding all your financial goals and the time-frame(s) you have to achieve them in. These factors will have a huge impact on the investment risk you can – and should – assume, along with the types of investments you choose. Whether you are seeking an income from your investments or a certain level of capital growth is a key question and will help determine the proportion of bonds, equities, funds and alternative investments which represent an appropriate split for your assets (the asset allocation for your portfolio).
It is generally held that the longer your investment time horizon, the more risk you can take on, since you will have more time to recover from any losses. On the flipside, if you are very close to needing a lump sum you have been investing towards, then you will want your money held in lower-risk, more liquid investments (see below).
A final and very important consideration is your liquidity needs, meaning how much money you need to have readily available and how easily you could sell (or liquidate) your assets to furnish that need.
Clearly, you should not have all your wealth tied up in highly-illiquid assets like property or difficult to trade stocks (although there are options like Lombard loans wealth managers can offer High Net Worth Individuals in these types of situations). Equally, holding most of your wealth as cash could lead to it being seriously eroded over time. Your wealth manager will be able to recommend highly-liquid investments so your reserve money can be working as hard as the rest of your investments.
As we have explained, there are several elements to a full risk-profile and you may now feel that any self-assessments you have previously carried out are inadequate. Forming a full picture that crystallises what you want your investments to deliver, and the level of investment risk which is appropriate for you at this point in time, as well as looking ahead, really calls for great expertise and experience.
Your financial adviser will put a lot of effort into achieving a deep understanding your investment objectives, looking at your circumstances holistically. They will also work hard to understand you as a person, as it is vital you feel comfortable throughout your investment journey. This is another reason why long-term relationships are crucial in wealth management – and why finding precisely the right provider for your profile and needs is essential.