Risk appetite: how can you tell if you have the stomach to invest?
Investors are constantly reminded that invested money has an element of risk attached, the most common warning being that the value of a person’s investments will fluctuate.
However, this is just a snapshot – there are four main categories of risk that people need to consider when assessing how comfortable they feel about investing their savings:
- Inflation risk: the risk that savings or investments won’t keep up with inflation which currently stands at 2.9%
- Volatility risk: the risk that someone will see large swings in the value of their investments
- Interest rate risk: the risk that investment growth will not keep up with interest rates being paid elsewhere
- Default risk: this is the risk that the institution holding someone’s investments will fail and the capital could be at risk.
Investors need to think carefully how they feel about the above risks (some are more likely to occur than others) and then match these against what you want to do with your money, as a person’s financial goals often dictate how much risk they are willing to take on. When we have conversations with people about their risk appetite, we often cover the below:
- What is your timeline? If you can leave your investments alone in the long-term you may feel that you can take on more risk as investments can often ride out any periods of volatility.
- What proportion of your wealth are you investing? If you are investing all your savings you might want to safeguard some, or all of it, to protect against loss of assets.
- What is your capacity for loss? This is different to risk appetite and someone’s capacity for loss should always be considered before they decide to invest money. It covers a person’s ability to absorb falls in the value of their investments and if these falls would have a negative impact on their standard of living. If someone has no capacity for loss they shouldn’t even be considering investing.
- What will you be using your money for when you cash in your investments? Are you looking to pay off debts, pay school fees, or use your investment as a source of income in retirement, for example?
How people think and feel about their money undoubtedly changes through life. However, there is one key time point where there is a clear shift in people’s risk appetite: retirement.
Prior to retirement people are more likely to have a larger appetite for risk. The main goal at this stage is to gather savings and, by working, most people have the ability, and time, to make back any losses on their investments.
However, once people retire risk appetite tends to dial down. This comes as their focus shifts towards long-term financial security. This could be either maintaining a sustainable personal income, or by offering financial support to younger generations. In retirement, people tend to take less risk than when they were in employment.
If you are looking to invest in sectors that may offer lower risk than others, consider those which are typically less affected by economic downturn, such as utilities, consumer staples and household products or telecommunications.
With all these factors to consider, it’s obvious that we can’t rely on numbers alone to represent a person’s appetite for risk. Tools, including attitude to risk questionnaires, are a great starting point.
However, a good investment manager will recommend regular re-evaluation exercises, combining risk calculating tools, market assessments and face-to-face discussions, to get a well-rounded picture of how and where a person would like to invest their capital. Only then is it possible to make effective investments that suit their circumstances.
Bob Szechenyi is investment director at Rathbone Investment Management