Do You Know Your Risk?

Risk is the hazard or chance of loss.  It and asset allocation are, I believe, two of the most important factors to get right when advising a client.  Everybody has a different perspective or attitude to risk and their investment portfolio must reflect that fact.  Also risk changes over time with retired people on a more fixed income likely to be more cautious than younger people.  There are various ways to classify risk but here are some of them:-

• Very Cautious: You are not willing to put any or only a small part of your capital at risk.  To this end you prefer to invest the majority of your capital in deposit-based accounts where your capital is protected and should be completely risk free.  You accept that the future purchasing power of your capital could be eroded by the effects of inflation over the medium term.
  
• Low:  Investments in this are designed to provide a relatively stable and conservative level of growth and/or income.  In return for the opportunity to earn more than from your deposit-type investments, you are willing to accept a low risk of capital loss.
  
• Balanced:  You prefer to invest in a broad range of core investments which may include property investments and stockmarket-linked schemes and where the overall returns achieved are closely linked to the performance of the underlying assets.  In doing so you have the opportunity of benefiting from real capital growth but the values of those investments can and will fluctuate according to market conditions.
  
• Adventurous: You prefer to invest in more specialised stockmarket linked investments in return for potentially greater capital growth.  Once again, underlying investment values will fluctuate according to market conditions and these fluctuations are likely to be more pronounced.
  
• Speculative: You are willing to invest heavily in equities of one form or another in return for potentially much higher returns.  At the same time you understand that you will increase the risk of losing part or all of your invested capital.

In my experience, very few people can, initially, tell me what their attitude to risk is.  Most are, in practice, lower risk who don’t mind losing profit but hate to lose capital; on the other hand there are some people who actually want to speculate in higher risk investments but don’t want to be considered speculators! 

It is vital, therefore, that any investment plan or scheme takes not only into account attitude to risk but also asset allocation and I favour a broad allocation.  This means that in addition to residential property, which the client may already own, I am a keen fan of some commercial property funds as well as fixed interest and equity investments from time to time.  In a number of cases I produce, for example, commercial property portfolios for clients who already have an equity portfolio managed by a stockbroker.  I also often combine lump sum commercial property investments, which can now be put in an ISA, with, for example, higher risk emerging market funds bought on a regular basis to benefit from so-called pound cost averaging.  This phrase means that if you buy automatically on a monthly basis you purchase more units when prices are low, when most people don’t buy, and fewer units when prices are high when, unfortunately, most people do buy.

What I am not keen on are equity investment schemes which lock money away for, say, 5 years even if they are perceived to be low risk and with a return linked to a stockmarket index.  Experience tells me that clients like flexibility even if money locked away is only a modest proportion of their portfolio.  Nor do I see much benefit for investors in some so-called tax efficient schemes such as Venture Capital Trusts because Gordon Brown has shaved back the tax breaks and VCTs are definitely a higher risk investment investing in small start-up businesses.

And then we come to the knotty questions of pensions.  Even as little as 10 years ago, pensions were the main way to save for retirement but they are not now.  Unless you are a lucky person to be a member of a well funded defined-benefit pension scheme, where your pension is based on length of service and pensionable salary at date of retirement, you face the problem of investing in a personal pension.  There returns depend often on stockmarket performance and annuity rates which have roughly halved over the last 10 years because people are living longer.

In some cases, it is not worth a person saving for retirement because they will lose state benefits.  In some cases, it is worthwhile if a) you are a high rate taxpayer and b) your employer is contributing too.  In other cases I am much less certain whether pension contributions are attractive although they are one way to produce future retirement income.

Please e-mail me your thoughts about attitude to risk, asset allocation and pensions.