To help you understand investment risk, here are three angles to view it from.
How our industry measures risk.
In finance, the term risk has developed a technical meaning that does not correspond with our everyday use of the word.
When we hear the word risk, we think: chance I could lose all my money.
A better way to think about investment risk is a range of outcomes around an average return on your money.
If the spread between the best and worst outcomes is wide, there is more risk. If the spread is narrow, there is less.
If you invest your savings in a diversified portfolio of equity (many companies), it is possible that every company in your portfolio across the globe and different industries could collapse at once, but it certainly is not probable.
Remember, the absence of fluctuations in your investments or savings should never be confused with the absence of risk. A guaranteed 0.5% interest rate a year makes it highly probable that you are not keeping up with rising living costs.
It appears that there is no risk due to the guaranteed rate, but the risk is in not keeping up with inflation and ultimately losing money over time.
How our industry measures your risk tolerance.
How much risk you can bear is another story. Here are some questions you may find on a traditional risk questionnaire:
When do you expect to need the money back? This is one of the most important questions. Often, the sooner you need it, the less investment risk you should take.
How much do you know about financial markets? I find this question less relevant. Extensive knowledge should not be a prerequisite for investing. Your trusted advisor’s role is to educate and ensure you make informed financial decisions suitable for your life.
What is your attitude toward risk? Because you and the questionnaire may define risk differently, it is important to ensure risk is well-defined before you can answer in a meaningful way.
Your answers to these questions are valuable information. However, the result of your questionnaire is often a number. Instead of a number that dictates your plan, I believe the answers to these questions should be considered individually and used as guideposts to determine a plan that suits your life.
How you experience investment risk.
Richard Thaler won the noble prize for figuring out that losing feels worse than winning feels good. The experience of investing is no exception, but if we can change our perception and understanding of risk, it can also change how we experience it.
How do you experience it?
Inspired by John Kay, Mervyn King and Nick Murray.