In investment terms, what does risk mean? Why is it a concern to financial advisers? And how can they assess their clients’ attitude to risk?

One way to consider attitude to risk is by examining the different types of investment that are regarded as high risk. For the purposes of this post, this is looked at from the point of view of a UK investor who is using sterling as his currency of reference, i.e. he automatically converts any foreign currency back to sterling. Some examples of higher risk assets are:

• Equities/shares
• Long-term fixed income bonds (defined as bonds with more than 10 years to maturity)
• Foreign currency cash

Their common feature is their volatility. Volatility means frequency of movement and range of movement up or down. All is well when the movement is upward but of course that is not always the case.

• We know that shares are volatile and that stock market indices can fluctuate widely – we have only to look at the steep falls in the market in 2009 and 2015 to have this confirmed.
• Bonds are regarded as safe instruments but the longer the maturity, the higher the risk. Bond yields are quoted on the basis of interest rates today; but who knows what will happen in 10 or 15 years when they mature? There is also a leveraging effect on the price of a bond: the longer the maturity the greater the change in yield as a result of any price movement.
• Cash is normally a no-risk investment but not if you are in a foreign currency. With this you are exposed to the movements of the currency against sterling; if sterling strengthens against it your cash is worth less in sterling terms and vice versa. Currencies are traded 24 hours a day all around the world so their volatility is notorious.

Shares, bonds and cash are long-term ventures and one has to accept that volatility is an inevitable side-effect to investing in them. An investor must have demonstrated an ease with potential risk if an adviser is to advise opting for these.

To assess a person’s attitude to risk a financial adviser needs to determine how well an investor reacts to downward movements in their portfolio. Can they handle it? Will they be able take the view that the decline is temporary and that things will recover? The risk profile questionnaires all investors are required to complete before being able to receive advice from an IFA are essentially designed to assess their attitude to volatility and consequently ensure they sleep comfortably at night. When the market is going up, all investors are bullish and think it will carry on forever; more important is how they react when that market starts to fall.

From my experience asking a client how he would feel if his portfolio dropped 10% in value is a clear indicator of his risk tolerance. If he is reasonably sanguine and understands that it is simply part of investing, you have a higher risk investor. If he says that he would not be able to tolerate that fall, then you have an indication that he is a conservative investor regardless of what he may think or proclaim.

So what is the significance of risk and why is it important for you? As an investor, you need to be conscious of your own risk profile and therefore your ability to deal with volatility. Your attitude to risk will determine the products your adviser offers you and above all it will condition your choice of investment.

 

Archiemidas

This article is not to be construed as financial advice. The views expressed above are those of the writer alone and do not constitute a recommendation to purchase, hold or sell. It must be borne in mind that the value of investments and any income will fluctuate.  The value of your Investment can fall as well as rise and you may not get back the original amount invested. Past performance is not a guide to future returns.