Balancing risk and reward

Nobody likes losing money and no one wants to take undue investment risks. On the other hand, there is a requirement to take on at least some risk in order to achieve most investment goals. The problem for many investors, however, is that they do not fully understand the nature of risk or their own attitude towards it.

"It is very important to define what risk is," says Investec investment manager Dan Moroney. "The investment industry can sometimes be accused of equating volatility with risk but they are not the same thing. For short-term investors, volatility does represent risk. For long-term investors with retirement savings and college funds and so on with longer terms than 10 years, avoiding volatility can actually represent a risk. The risk in avoiding volatility is inflation eroding the value of savings.

“For longer-term investments, the riskiest asset can be cash,” he adds. “It’s going to deliver below inflation returns for the long term. The ability to take long-term view is the most potent weapon people can have in this environment. You can invest in assets that will be volatile as long as they are diversified.”

Trevor Booth, of Mercer Financial Services, explains that a very different approach to saving and investing is needed for a short-term goal, like buying a new car in three years, compared to a long-term goal, like providing for your income in retirement. "The higher the return you seek, the higher the level of investment risk you will need to tolerate," he notes. "Usually, the higher the level of equities or shares in your chosen investment, the higher the risk will be. Diversification of the assets in your fund is the most critical part of managing your investment risk: diversification means using different types of investment rather than putting all of your eggs in one basket."

Colm Power of Davy advises that risks can be categorised into two key types. "There is the risk of permanent loss of capital where you make an investment and risk losing some or all of it. This is most common in concentrated investments where people put all their money in assets like bank shares or leveraged property which we saw in the Celtic Tiger era. That's the extreme end of risk. The other key type of risk is volatility risk. The bumps in the road that may affect the value of your investment. A diverse portfolio may see some losses in the short term but the time horizon is important. A diverse portfolio should be able to ride it out in the longer term."

This may not be the case in the short term, of course.

“You should only take whatever level of risk you are comfortable with,” Power adds. “Your attitude to risk should be determined by your goals and time horizons for your investments. If it’s an education fund, you might be able to take some balanced risks if you start it early enough.”

Approaches need to be varied depending on the assets involved, according to Owen Redmond of Goodbody. "People have different pools of assets and shouldn't have the same risk approach to all of them. If you have a goal such as buying a house or upgrading property and you need to accumulate a deposit, you want a defined path to building up that lump sum. A lot of people couldn't take it if there was there was a 10 per cent or 20 per cent market correction. There are known knowns like education funds. You know on the day a child is born when they are likely to enter second-level school and university. You want to know that the money will be available when needed."

Understanding the nature of risk is just the beginning. People have to learn what level of risk they are comfortable with. “A number of years ago people were just asked if they had a high, medium or low appetite for risk but there are a number of quite sophisticate tools on the market now,” says Redmond. “We use the Oxford Risk tool which is one of only three such tools passed fit for purpose by the UK financial regulator. It assesses people’s comfort levels in relation to certain events and then sees how they would react if market went down. Loss ability is another huge factor. If you have several million euro and you lost €200,000 it won’t matter as much as if you have €400,000 and have invested €200,000 and lost 10 per cent of it. People also need to update their personal risk profile on a regular basis.”

Trevor Booth says that assessing investment risk and deciding on a suitable fund or portfolio is an area where most people will benefit from getting professional advice. "With interest rates very low at the moment, some investors who would traditionally have a low risk approach are now looking to take higher levels of risk to improve their return. This tendency is understandable, and in some ways has been forced by European Central Bank policies – nevertheless, it could represent a trap for the unwary. An advisor can help ascertain what level of investment risk you can tolerate, and how you should go about aiming for the return you need."