Last Updated on 7 July 2020 by Dan
Hello everyone! This post continues our series for novice investors on things to consider when starting to invest. This builds on the last point in the “Starting to Invest” series where we looked at some of the different products on offer in the marketplace.
Today we focus on understanding your tolerance for risk, which particularly applies when going down the stocks and shares route.
Why do I need to consider this?
The reason for this is that the stock markets is volatile and can move up slowly (and occasionally quickly) and down very fast indeed. We need some of that volatility so we can get returns when it moves upwards, but also need to make sure we can tolerate losses when it drops.
Usually the downturns come from some kind of trigger event, but it can be unpredictable what that factor will be. As a result trying to time the market to sell at the right time is a bit of a fool’s game, even for the well-informed. Crashes are so much easier to predict with hindsight!
What do I need to consider?
There’s a few questions we need to ask ourselves:
– We need to consider time risk: Do I have any known life events (for example) buying a house that I am reliant on these funds for and may need to drawdown on them?
If you do, you need to adopt a more cautious approach, as you cannot predict if the timing of that purchase will coincide with a downturn in the market. It may be sensible to think about what you have in total and what you need for the purchase. You could then take a dual risk strategy, and carve out what you know is your minimum needed amount to put low risk investments and then any remaining in a higher amount.
– We also need to consider loss-aversion: If I’m looking to draw down on my investments, what percentage of them could I lose before it begins to affect my lifestyle?
This one is really important – after all you’re investing for a purpose, no matter if it’s to have a solid financial bedrock under you for security or to save up for something in particular. So you want to be sure you’re not putting yourself in a position where you’d be relying on funds which aren’t there!
How do I work this out?
The best way to understand your profile is with a simple financial risk profiling questionnaire. Just to point out as well that if you’re engaging with a financial adviser at all, these are the kind of questions you’d hope they’d be asking you.
The below are just sample to provide you with a broad idea of the kinds of questions to think about – it’s too simplistic to be used for serious purpose, but should at least provide a broad idea of the types of questions you should think about.
In the questions, I’ve focused mainly on the loss-aversion element mentioned above – you’d need to factor in the time risk element as well.
|1. Which of the following statements resonates with you most?|
|A. My investments should be completely safe; I am uncomfortable with the idea of potentially losing money.|
B. I understand there’s an element of financial risk in investing but I would like this to be a small as possible, even if it limits my gains.
C. I am comfortable taking some risk as long as the rewards are appropriate, but I could not tolerate a single large loss.
D. I am comfortable taking larger risks as long as the rewards are appropriate. I can tolerate a large loss, in knowledge that markets will usually go up again over time.
E. I am comfortable making speculative investments in higher risk companies.. I acknowledge a proportion of these may fail, but the gains from a successful investment make it worth it.
|2. The maximum percentage I would be comfortable with my portfolio value dropping in a single year is.|
|3. Of these portfolios, I would choose|
|A. 100% invested in Company X, which provides an estimated return of 1% a year and a 0% likelihood of loss. 0% invested in Company B, which provides an estimated return of 3-5% per year with a very small likelihood of incurring loss instead.|
B. 60% invested in Company X, which provides an estimated return of 2% a year and a 2% likelihood of loss. 40% invested in Company B, which provides an estimated return of 3-5% per year with a very small likelihood of incurring loss instead.
C. 50% invested in Company X, which provides an estimated return of 2% a year and a 2% likelihood of loss. 50% invested in Company B, which provides an estimated return of 5-7% per year with a a small to moderate likelihood of incurring loss instead.
D. 40% invested in Company X, which provides an estimated return of 2% a year and a 2% likelihood of loss. 60% invested in Company B, which provides an estimated return of 10-15% per year with a moderate likelihood of incurring loss instead.
E. 10% invested in Company X, which provides an estimated return of 2% a year and a 2% likelihood of loss. 90% invested in Company B, which provides an estimated return of 30-50% per year with a reasonably high likelihood of incurring loss instead.
|4. Which of these best defines your needs with regard to the money invested?|
|A. I’m reliant on my investments for day-to-day life, and need to be able to access them at all times, and am likely to dip in and out.|
B. I can tolerate small, known periods where I can’t touch my investments, but I’ll want to use them for day to day expenses when they mature.
C. I actively make a conscious effort to leave my investments alone, but occasionally spending requirements will mean I may need to take some money for my investment pot.
D. I intend to leave my investments alone and separate from the rest of my finances, but would need access in emergencies or to fund larger purchases like a house.
E. I am likely to have little need to touch my investments on an ongoing basis.
You may have noticed that in the above we’re asking very similar questions.
The reason behind this is purely confirmatory – sometimes we view a question slightly differently if framed a different way. The quiz is therefore designed to see if you reach a consistent answer. Ideally, you’ll have probably come out with a similar letter at least on at least questions 1-3, or one letter out at most. If that wasn’t you – go back and have a think about why.
So what might this mean for me?
|If you answered mostly……|
|A. These largely describe a current account type investment, and suggest you are a very cautious investor with nearly no appetite for any risk.|
B. These largely describe a mix of current accounts and bonds, and suggest you’re a moderately cautious investor.
C. This describes a mix of bonds and low volatility equities, and suggests you are a balanced investor.
D. This describes being primarily invested in slightly more volatile equities with a small holding in bonds, and suggests you’re an moderately aggressive investor.
E. This describes being entirely invested in volatile equities or more speculative investments, and suggests you are a very aggressive investor.
You can also check out the other post in the “Starting to Invest” series on why investment is a good idea here.
Next time we’ll be looking in more detail at why (if you can) investing for the longer term can be the most successful route. Until then!