The Garrulous Jay – Risky Business

Making any investment involves taking risk. Deciding on the level of risk one is prepared to take should therefore be the foundation of every investor’s decision-making process.

Business success is often derived from taking risk, in a world that is itself a risky place. It is less risky to lend to companies, than to buy their shares. Some geographies are more risky than others, as indeed are some sectors. Companies at different stages of their development also carry differing levels of risk. And over time entire markets can be more or less risky based on changing economic cycles.

Deciding how much risk to take is not, therefore, a straightforward process. As well as the external considerations cited above, every individual is different in terms of the level of risk they intrinsically feel comfortable taking, their personal circumstances, their objectives and their experience.

Helping people to arrive at an optimal level of risk – there are no absolutes in this process – is therefore a critical part of financial planning. As can be seen from the points above, it is a complex and nuanced process.

Providing a structure or framework for this process can help.

For example, taking each client’s circumstances into account in terms of their existing investments, their experience and understanding of investment markets, their overall wealth and the time over which they are investing can provide pointers.

One must, however, guard against rigidly applying rules to the above process. For example, consider a teenager with no previous investment experience, no understanding of markets, no existing investments and just £1,500 in the bank. It might be thought that they should take a low level of risk.

But what if they were told on their 18th birthday that their parents had set up a pension for them when they were born, and for which they we now responsible? Given they would not be able to draw on the product for four decades, it might be quite wrong to guide them towards the bottom end of the risk spectrum.

In addition to having a framework, so-called risk profiling tools can be a useful way of helping people to establish how much risk it might be appropriate for them to take. By answering a series of questions or making choices between different options, these products can provide pointers towards the individual’s risk appetite.

It is important, however, to recognise the limitations of these tools: they won’t provide ‘the answer’. They cannot easily take context into account including, for example, the time horizon over which an investment is being contemplated or the prevailing market conditions when the investment is being made.

Such tools should therefore be used as a means by which to facilitate a conversation between a prospective investor and their adviser: a mechanism through which to explore and guide towards the final decision as to how much risk to take.

Investors should never forget that their future prosperity could be damaged as much by taking too little risk as by taking too much.