17 May 2010

Risk and Return

One of the most important parts about recommending where an investor should put their money is to assess their attitude to risk and return.

The unavoidable fact is that risk and return always go together – if you put your money in a current account there is very little risk of losing it, but very little opportunity for it to grow. Conversely, if you invest in a small company which is just starting up there is a high risk of losing all your money, but if it works out, there is a possibility of a high return.

But the risk to your capital value is not the only type of risk. If you regularly follow the FTSE100, for example, you might consider it an unacceptable risk to be under-performing that index. The volatility of an investment is also something to consider (and is often used synonymously with "investment risk"): if an investment goes up and down rapidly (such as small company shares) that is a different level of risk to one which goes up and down more slowly (such as property).

There’s a lot of maths behind assessing risk, including the “normal distribution” curve, and “standard deviation” which you may (or may not!) remember from O-level / GCSE maths. But to make it more palatable for the average investor a risk questionnaire is typically used, resulting in a score of 1 to 10. That result encapsulates the investor’s desired balance between risk and return.

For a simple portfolio it is then sufficient to pick a fund or two which match that level of risk – typically a managed fund which itself invests in a range of different types of asset. For a larger portfolio, it is worth considering the “asset allocation” – in other words, the asset classes like equities, fixed interest, property, and cash (although these can be sub-divided further). That’s because diversification is an important part of reducing the level of risk for the same level of return - particularly over a longer time period.

Having said all that, there is a lot more detail possible, and a lot more questions which could be asked of the investor which will affect the recommendation, including whether you are investing for growth or income, how long you expect to invest for (or at least the minimum time), the level of loss you would be prepared to see in any one year, how far you are willing to stray from a benchmark index (like the FTSE 100), and how much notice you expect to give when considering surrendering an investment.

So if I ask lots of questions about your attitude to risk, the level of return you want, and so on, just humour me! Ultimately it is about understanding and then delivering your objectives without scaring you too much on the way!

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