"Risk can also be relative."
What level of risk are you prepared to accept with your investments? Some people base their answer on what’s in their portfolio. Someone with a high percentage of shares, may judge their risk tolerance high. Others with more cash and fixed interest assets may think of themselves as conservative.
But there is more to risk than the different assets you feel comfortable with.
Working out your risk profile is useful because it helps you to assess different investments. For example, an investment that’s considered high risk is unlikely to be appropriate if you’re a very conservative investor who is not happy to take risks.
Risk is often seen as the possibility of losing money but there’s also a risk that by choosing the wrong types of investments you might not achieve your financial goals.
The challenge is to work out your long-term goals, then decide the right path to reach them. This process is very important and could take a couple of goes before you get it right.
Risk can also be relative.
Some see risk as the chance of being left behind – missing the boat on an investment opportunity. The property boom was a classic example of this – people were scared that if they don’t get in, they will never be able to afford a property.
But reminding yourself of your long-term goals can help you to keep a level head when the market is surging.
Good and bad risks
Not all risk is bad news.
Investors need to be smart about risk – this is critical to success – and you can start by understanding the concept of risk adjusted return.
One popular method of calculating risk adjusted return is known as the Sharpe Ratio.
In brief, this ratio works out how much extra return you should be getting for the amount of risk you have taken on.
For example, Bill’s investment has returned 10% pa, while Jan’s has provided 8%. On the surface you might think that Bill’s portfolio is better. However, if Bill took much larger risks to get that return, then Jan may have a better risk-adjusted return.
To see the equations used to work this out, try searching Sharpe Ratio on the web.
Back to basics
Here are the nuts and bolts of investment risk:
The main kinds of risk are market risk and share-specific risk. Market risk is what we experienced over the last two years with the global financial crisis. The only way to avoid this risk is to stay out of the market. Share- specific risk is usually affected if you hold only a few shares. The solution is to diversify.
If you’re not sure about your risk level when it comes to shares, then ‘paper trade’ for a while. If your hypothetical portfolio drops by 10%, check your reaction: sell to cut your losses, see it as a chance to buy more, or do you lie awake at night wondering what to do.
Your risk profile is neither absolute nor definitive. It should be reviewed regularly and discussed with your partner or adviser.
As always, taking a long-term view and choosing appropriate assets to match your goals is the best way to ensure a good night’s sleep.
And don’t forget to review your strategy quarterly.