The risk-return trade-off is a concept that every investor should be familiar with. Stated simply, it means that to gain a higher potential return on an investment, you have to accept more risk.
It’s also important to understand what those risks might be, like the risk of losing some of your capital, the risk of fluctuating returns, or the risk involved in holding cash in the bank as inflation eats away at the value of savings.
You can’t avoid risk, it’s inevitable. The trick for the canny investor is to manage it carefully, by creating an investment portfolio with a risk profile that matches their needs.
Of course the needs of different individuals can vary enormously. A 59 year-old hoping to retire at 60 probably won’t be willing to risk the capital in their pension pot, so they may choose to accept a lower return in exchange for greater security. While a 25 year-old with far less capital may be willing to accept much higher risk in the hope of benefiting from higher growth.
There’s also individual “appetite for risk” to consider. But of course it’s not actually the “risk” that people hunger after, it’s the potential rewards – and investors should think carefully about what they’re willing to put on the line before they go chasing them.
Assessing clients’ attitudes and appetite for risk is currently receiving a good deal of focus from the Financial Services Authority and is a key area in our planning process.
As important is a client’s need to expose their funds to unnecessary risk. A client may have both the appetite and attitude to expose their funds to a relatively high level of investment risk. However, what if they don’t need to? Why try to achieve a return of 9 or 10% a year when you only need a return of 6% to achieve all your goals, with a good deal more peace of mind and probably experience less of a roller coaster ride?
This is where life planning and financial planning come into their own. Using leading cashflow modelling tools can help planners and clients understand the key aspects of risk on a very individual basis and help answer the key question ‘how much do I need?’.
For further information about assessing your risk profile please contact us.