In the previous blog, Richard T Lishman explored the basics of investment, types of assets and diversification in order to establish what balancing a portfolio means. Moving on, he now discusses the importance of creating a risk profile, as well as risk versus reward.
Creating a risk profile is key to the balancing process. In essence, it finds the optimum level of risk that can be undertaken during investments by using three specific considerations. These are:
Risk Required – which is the risk associated with the return required to achieve your intended goal using the financial resources that are available to you.
Risk Capacity – which is the level of financial risk that you can realistically afford to take.
Risk Tolerance – which is the level of risk that you feel personally comfortable with.
While the first two are financial characteristics that can be calculated using financial planning software, the latter involves a psychological assessment, which is carried out by way of a psychometric test. When analysing the risk scale, a scope of one to ten is usually used, with five typically representing a balanced attitude towards investment risk.
Risk Versus Reward
As you might expect, with risk comes reward, so if you decide to play it safe, you may miss out on the potential for better returns. Plus, if your money doesn’t grow over time, the effects of inflation could even see the spending power of your money fall. As a result, sometimes it can pay to take a leap of faith – albeit calculated – than take no risk at all.
However, one must also be aware of systematic and unsystematic risks. Systematic refers to a risk that affects the whole stock market such as a global event. As this cannot be reduced or diversified away it is known as a non-diversifiable risk. Unsystematic risk is specific to the company or industry that you invest in. Unlike systematic risk, it can be reduced through diversification.
Say Dr B chose to invest into a bank account; she knows that her hard-earned money will be there year-on-year attracting a small amount of interest annually. However, when you take into consideration the tax that is charged on the interest as well as the effect that inflation has on the deposits, it is likely that Dr B’s money will fall in value. Thus, for medium to long-term investments, it could be argued that cash assets are actually high-risk investments.
The Balancing Act
Altogether, creating a profile and remaining diligent to weighing up risk versus reward is invaluable to ascertaining what your actual risk is, though of course it is a concept that can also be subjective. Although there is never any guarantee that anyone will make any money, one should always aim to maximise returns while minimising losses on a year-on-year basis.
To find out more on rebalancing according to overexposure to risk, size of portfolio and tax efficiency, watch this space for the last blog in the series.
Posted by Gemma