How much risk is right for you?

When investing your money

Whether you’re an existing investor or just starting out and you’re confused by all the ‘mumbo jumbo’ jargon of investing, don’t worry …

…most people, including some advisers are confused about it too – and for good reason, as you’ll find out below!

You can’t rely on the theory!

What might surprise you is that a lot of investment risk theory (often dressed up with impressive-sounding mathematical terms – like standard deviations and efficient frontiers to name but two) is unreliable.

Markets are driven by human activity – and our mood swings are completely unpredictable.

Charles Mackay. Mad in herds

So, take particular care if you see a statement like this:  ‘Our investment process is based on a Nobel Prize-winning theory’ …

Why?

Because when it comes to the theories of how stock markets work, the economics profession has given Nobel prizes to two people with diametrically opposed views.

Yes, I know that sounds incredible but it’s true. So, you need to know which Nobel Prize winner your wealth manager follows – to decide on the value of that – and if this background intrigues you, you might want to learn:

How two Nobel Prize winners can hold opposing views

How to check if your adviser really understands risk and

Why you need to think one step beyond ‘efficient frontiers’

In the meantime, let’s just stop pretending that we can predict the chance of a big market correction, we can’t. That much has been proven yet again, by recent market moves (if it needed to be after the crashes of 2000-03 and again in 2008-09)

Let’s simply focus on what you really need to know – when deciding how much risk to take with your money.

Have you chosen your box?

Now, I’m assuming that you’ve already chosen your investment box (aka wrapper) for your money.

This might be a pension plan, an ISA, a simple investment fund or something else – and getting the right boxes for your savings and investments is critically important.

So, whether you’ve done that already, or you’re reviewing which boxes might be right for you now, be sure to use a solid process to select them. I’ll share a super solid process for selecting the right boxes for your money in a future Insight.

So, be sure to get notified about that.

Money Box under the bedKeep a close eye on charges

Of course, you’ll also need to keep a close eye on the total level of charges you pay (for your investment box, for the funds inside it and for any advice that surrounds it) because these charges can (in some cases) add up to so much as to make the risk of investing a complete waste of time!

If you’re not already familiar with the critically important issue of charges, you can find out more here and here

Focus on four factors

Once you’ve settled on a fair value investment or pension wrapper and before you get into the grisly detail of fund choice, consider these four factors to decide how much investment risk to take – on each of your financial life goals.

Be sure to consider:

  1. Your general attitude to investment risk – sometimes called your risk tolerance.
  2. Your need for investment risk, on each of your financial goals.
  3. Your capacity for investment risk, on each of your goals.
  4. Whether your chosen investment assets (Shares, Bonds, Property for example) are especially expensive, or cheap, compared to long-term average ‘value’ measures. (more on those another day)

It’s important to pay close attention to all four points. And, if you use a financial adviser/wealth manager (which I’d encourage most people to do) be sure to check that your adviser is considering all four of these points too. Sadly, not all of them do.

You also need to pay particular attention to the third point in that list – your capacity for investment risk – because this might reveal a need to take a different investment approach on each of your financial life goals.

Really, why would that be?

Well, let’s assume that you have a lump sum of money that you’ll absolutely need to be available (e.g. to help a child through college) in 5 to 7 years’ time. You might choose to invest this lump sum in a different (far less aggressive) way compared to, say, the regular investments you put into your pension, if you won’t need that money for another 20 or 30 years.

So, taking account of your capacity for risk can help you financially in two ways:

First, it will help you consider the need to protect your capital on shorter-term and lump sum investments.

Second, it might persuade you that it might be OK to go for higher returns on your longer-term, regular investments… and doing that can significantly reduce the cost of achieving your goals 🙂

You can learn more on all these issues in my book, ‘Who misleads you about money?’ 

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Thanks for dropping in

Paul

For more ideas to achieve more in your life and make more of your money, sign up to my newsletter and, as a thank you, I’ll send you my ‘5 Steps for planning your Financial Freedom’ and the first chapter of my book, ‘Who misleads you about money?’ What’s not to like?
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