Risk and reward are opposite sides of the same coin, and it is almost certain there will be a trade-off between the two to achieve your long-term investment goals.
Investment guru Warren Buffett is quoted as saying that “risk comes from not knowing what you’re doing”. Take this billionaire’s advice and understand the risk of the various types of investments before leaping in – and, importantly, know your own risk profile and whether you are risk friendly or risk averse regarding your investments.
For the average person, risk means the temporary or permanent loss or decrease of your investment value. But without taking on calculated risks, your rewards from investing make be inadequate, so make risk your friend.
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A good financial adviser can help establish the optimal level of investment risk that will let you achieve your investment goals, taking into account your risk profile. Legislation requires that an adviser obtain all the necessary information to establish your needs and objectives and to recommend products in accordance with those needs and your risk profile.
Determining your risk profile is usually done via a questionnaire. There is debate in the industry about the appropriateness of some of these questionnaires, but as long as your adviser assesses your risk profile holistically and takes into account your financial goals, investment time horizon, existing investments and other relevant factors – and you stick to the strategy designed for you – you should be able to meet your goals.
Those goals can be as simple at buying a new car in four years’ time, paying for the education of a child in 18 years’ time, or being financially secure when you retire.
There are three aspects to risk. All three should be taken into account when deciding how to allocate your investments between cash, bonds, property and shares, or to a combination of these.
- The required risk is associated with the return you need to reach your investment goals.
- Risk tolerance is your emotional capacity to withstand losses from your investment. It speaks to whether you stick to your strategy without panicking and ditching the plan.
- Risk capacity is your ability to financially absorb any investment losses.
Advisers may assume you are comfortable with a high level of risk because you enjoy activities such as parachuting and bungee jumping, but that is not necessarily true for the way you feel about taking large bets with your investments.
Your risk tolerance should be determined through the use of questions that are valid, relevant, reliable and not too technical. An example of a good indicator of your risk tolerance is whether you would accept a decline in your investment value of, say, 10% over any 12 months to achieve a return of inflation plus 3% a year over three to four years. That quantifies the risk objectively over a certain period, is not too technical and is relevant to the investment at hand.
Furthermore, a financial adviser should work out the possibilities and probabilities of an investment and advise you on the potential for a decline in the value of an investment under consideration or one that is recommended for you.
Having your risk tolerance assessed is important, otherwise you could be left unable to make informed decisions, or it could lead to inappropriate advice. You may, for instance, panic when the market drops sharply and then sell your investment, which could have a significant impact on your financial wellbeing in the long run.
It is important to understand that risk tolerance is only one part of the assessment of your risk profile. You may well sleep soundly if your strategy relies on conservative investments, but it may be woefully inadequate to help you achieve your long-term financial goals. This is where the assessment of the next type of risk comes into the equation.
Risk required to achieve your goals
You need to differentiate between risk tolerance – how much risk you feel comfortable taking on – and the risk you need to take to achieve your long-term investment goals.
This measure of risk will take into account the amount you need to save, your time horizon and the returns of the various asset classes such as cash, bonds, property and shares. Generally, shares are regarded as the most risky and cash (money in the bank) as the least risky.
The higher percentage of shares of a fund or investment, the riskier the investment is likely to be over the short term.
Understanding the difference between volatility and risk is important. If an investment is volatile, it’s not necessarily risky.
Keeping your money in cash over the long term is considered risky because you will not be able to outperform inflation and your money will lose its real value over time.
If you want your capital to beat inflation, you will have to embrace an investment that contains growth assets such as shares, irrespective of their volatility. Such an investment will give you the best chance of outperforming inflation over the long term, as long as you are patient.
Tips on investing
— Start investing from an early age. Time will see your money grow, especially if you harness the power of compound interest.
— Be disciplined about investing on a regular basis.
— Know what type of investor you are. Nobody understands you like you know yourself. You and your adviser have a joint responsibility in the financial planning process;
— Set financial goals. Where do you want to be financially in five, 10 or 20 years and when you retire?
— Stay the course. Delayed gratification is what will build financial wealth. Don’t be tempted to ditch your investment strategy to go on an overseas trip when many of your friends are doing so.
The following example illustrates the trade-off between risk and volatility, which is the variation in returns over time from an investment.
Assume you have R1-million in capital, retire at 65 and draw R5,500 per month that grows at 6% inflation over time.
If you want to avoid volatility and opt for a conservative strategy aiming to deliver returns based on the consumer price index (CPI) + 1%, for example, by putting your money in the bank, your money might run out around age 80. But if you invest in a more growth-orientated portfolio, with 60%–70% in equities, aiming for CPI +5% over the long term, you can add almost 15 years to the life of your money.
Consider the following, which is based on the actual returns of a typical balanced unit trust with an investment mandate of CPI +5% over different rolling periods between January 2007 and October 2017.
Over one year, your return would have been between 1.4% and 25.8% by the third year of investment; the returns would have varied between 6.6% and 18.8%; and, after seven years, the range is between 12% and 15%.
This demonstrates that if you invest for the long term, most of the volatility of returns is removed.
It’s all very well for your adviser to establish your risk tolerance – for example, that you may be comfortable with a risky investment to deliver an average return of 30% per year to achieve your financial goals, which may be worth 50% less in any one year. However, these kinds of return expectations are unrealistic and often lead to permanent capital losses.
Investors’ capacity for risk
Your risk capacity is determined by analysing whether you have sufficient income and/or money in liquid cash investments to absorb negative market movements over the short to medium term. You want to avoid cashing in on your investments when their values are low, because in such an instance you would be realising a permanent capital loss in the amount withdrawn.
Understanding your appetite for risk is key. Where there is a mismatch between the risk required to achieve your financial objectives, your risk capacity and your risk tolerance, the adviser’s role is to guide you through the trade-off decisions needed to reach an optimal solution.
This guide was written by the Money editorial team at Tiso Blackstar, sponsored by Discovery Invest.
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