Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Understand your level of risk appetite
Investing is always a risk, whether your money is in a government-backed bond or emerging markets equities, but there a great many different levels of risk.
Every investor will have a different appetite for and tolerance of risk and taking the time to assess what yours is can mean the difference between sleepless nights and a comfortable investment journey.
Risk tolerance is, simply, how much volatility you can stand in your investments before it makes you feel uneasy. One of the first things that is said about investing is that it should be for the long term as this gives you the time to ride out any ups and downs in the stock market, but these ups and downs should never be so extreme as to make you panic.
HOW MUCH RISK ARE YOU PREPARED TO TAKE?
While some investors are ready to ramp up the risk in the hope of achieving greater gains, others would prefer a steadier ride; this latter strategy might mean the potential returns are not as high but should ensure you can sleep at night.
Patrick Connolly, chartered financial planner at Chase de Vere, says: ‘When people hear “risk” in association with investing, the first thought tends to be about loss of capital. But risk goes much further than that: it is about the full extent to which investments can make or lose money.
‘If you can understand what risk is really about and can identify your own attitude to risk, then you will be in a better place to create a portfolio that includes risk at a level you are comfortable with.’
But assessing your own appetite for risk can be difficult as it is an inherently subjective concept: one person’s high risk is another’s steady Eddie. Risk questionnaires are one way to help determine what level of risk you are likely to be comfortable taking.
ANSWERING THE RIGHT QUESTIONS
Risk questionnaires can take numerous forms. Many robo-advice websites, such as Nutmeg, have these built into their set-up. These ask new clients to answer some relatively simple questions to help direct them to one of a number of ready-made portfolios – the one that is most suitable to their needs.
Nutmeg asks your investment goal and time horizon and how much you will invest before asking you to select from risk/reward options including cautious, steady, balanced, growth and adventurous. Wealthify, another robo-advice site, asks the same questions: what is your goal, how much are you investing and for how long. It asks investors to rate their investment style on a scale of one to five.
Such sites may be suitable for those starting out with small amounts to invest, but other investment groups offer more sophisticated questionnaires. Standard Life and Oxford Risk pose ten statements, including ‘My friends would say that I am cautious’ and asks investors to say how accurate the statement is ranging from strongly disagree to strongly agree.
Other statements include: ‘Even if I could get high returns, I would prefer not to invest my money in something that might decline in value’ and ‘Being financially cautious is important to me’. Investors are then ranked on a scale from 1 to 50, to indicate whether they would suit a lower, medium or higher risk investment.
GETTING MORE THOROUGH
There are more thorough questionnaires available to investors too, although these may cost money or be available through a financial adviser. One such example is Finametrica, which asks 25 multiple choice questions such as ‘When you think of the word “risk” in a financial context, which of the following words comes to mind first: Danger, Uncertainty, Opportunity or Thrill?’ Other questions include ‘Would you prefer more job security and small pay increase, or less job security and a big pay increase’ and ‘How easily do you adapt when things go wrong financially?’
While such questionnaires are more in-depth, there are still limitations with using these. A question about how an individual adapts when things go wrong, for example, may be relevant if they are picking investments for their own stocks and shares ISA but will not be so helpful if they are setting up a Junior ISA for their child or grandchild.
Connolly adds: ‘An online questionnaire, such as those available from a robo-adviser, doesn’t benefit from the engagement, further probing and empathy that you would experience if you’re face-to-face with a financial adviser.’
SWAYED BY MARKET SENTIMENT
There is also the risk that the answers given are influenced by the current environment; investors may, for example, feel more open to risk when stock markets are soaring and more cautious after market falls, which could influence the way they interpret and answer questions.
Martin Bamford, managing director at adviser firm Informed Choice, says: ‘When investing money, it’s important to consider more than just your attitude to risk. You need to think about your capacity for loss and your need to take risk to meet financial goals.’