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Investing and Risk

Investment involves risk. The amount of risk you choose to take is up to you. This section will help to guide you in choosing the level of risk appropriate to you.

What do we mean by risk?

Primarily, when we talk about risk we are talking about the possibility of falls in the value of an investment. However in reality this is only one risk to be considered. Another risk that must be considered is the risk of inflation. Inflation will reduce the value of savings over time. Over the long run, inflation threatens cash deposits more than it threatens investments such as equities and property that are traditionally considered to be high risk.

What is high risk to one person may not be considered high risk to another.

Factors that may influence the level of risk you should take

Listed below are a number of factors that you should consider when deciding how much risk you should take with your investments. Ultimately these are based on common sense. 

1) How much could you afford to lose?

When investing, it is not advisable to risk money that you think you will need to live on in the relatively near future. The level of risk is thus to a considerable degree dependent on factors such as your savings (reserves), job security and the stability of your income.

If you have plenty of other reserves – for example, a high guaranteed income or a large amount in a safe deposit account – then you can probably afford to take a medium or even a medium-high risk approach with your investment money.

If on the other hand your job is insecure, or you need to supplement your income with drawdown from your savings, a minimal, low or low-medium risk approach could be sensible. Alternatively, you could specify in advance the amount you will need to keep in reserve, and invest the balance on a medium or higher risk basis.

2) How much growth are you targeting?

The investment return that you are expecting must be considered as it will dictate the level of risk you must be prepared to take.

For example, an investor could target 10% per annum growth on investments. This, however, is a very high rate of return and would necessarily involve a very high amount of risk. If things go as expected, the returns would be significant: given compounding of returns, a 10% per annum growth rate should see an investment double in value in 7 ½ years. High risk, however, means that if things go wrong a large amount or all of the original investment could be lost.

If you simply want a better return than you can get from cash, a low-medium risk approach should be able to deliver this, and even if things go wrong the damage to value should not be too significant and should be recoverable.

3) How long is your timescale for investment?

The timescale for your investment will affect your investment decisions. Someone starting out on their career and investing in a pension may have 40 years to retirement. They may need their fund to grow very significantly to provide them with a reasonable retirement income, suggesting a medium-high or high risk approach. A short-term drop in markets should not be a particular concern. After all, if a person is many years from retirement, they have plenty of time for their pension to recover.

However, the same young person might intend to save for a deposit and buy a house once they have accumulated sufficient money. Investing these deposit savings in higher risk assets pending property purchase is probably unwise, because the timescale is so short and a drop in markets may not be recoverable in the time available.

One must also consider the risk of inflation. In the long run inflation can eat away the value of low risk investments if they don’t deliver adequate returns. In cases where money is held for significantly more than 10 years, it can be argued that inflation is an even bigger threat than a drop in markets.

As a rule of thumb, the more time you can leave your money invested for, the higher the level of risk you can afford to take.

4) Are you investing continuously or in a single lump sum?

Suppose Sean places €10,000 in a lump sum investment. For simplicity, suppose that the investment drops 10% in value in each of the first 3 years, then gains 10% in value in the next 2 years. This has been a bad 5 years for this investor. His investment is now worth €8,821 and he has experienced an overall loss of 12%.

Now suppose Mary uses the same investment over the same timescale, but invests €2,000 at the start of every year. At the end of the five years, Mary’s investment is worth €10,522 and her overall gain is 5%. She may still be disappointed (5% growth in 5 years is not a great return) but she has not lost money. This is because when the markets fell, she was buying into the investment at a lower price.

Investing continuously is lower risk than investing in a single lump sum: a fall in markets does not have the same impact if there is still new money coming in at the lower level. If you intend to invest continuously rather than in a single lump sum, it may be possible for you to invest in somewhat riskier assets than you would use for a lump sum subject to all the additional criteria outlined here.

5) What would your response be if your investment fell significantly in value?

You should carefully consider your potential response to investment losses when making your investment decisions. Take the following example:

James is an investor. He does not have any need for his investment money for 20 years. Even if he lost all of his investment, he has enough resources to prevent his lifestyle from being impacted. On this basis, James decides to invest in a medium-high risk manner.

In the first year of his investment, there is a severe financial downturn. Because James has a medium-high risk portfolio, his investments are hit hard. At the end of the year, James finds that they have fallen by 30% in value. The global economic outlook is very poor. James feels he has made a mistake and that these are bad investments, so he takes his money out and puts it in a bank account.

Even if markets recover in the next two years, which they usually start to do before the economy improves, James cannot benefit. He chose a risk level that was simply too high for him to bear.

There are very few situations where an investor should make an investment that could interfere with their peace of mind.

Below is a rule of thumb guide to how your tolerance of losses should guide your approach to risk.

Loss tolerance

The most risk I should take is:

I cannot tolerate any short term loss

Minimal Risk: Cash deposits, State Savings Products

I could live with a short term loss provided a guarantee is applied that at some stage in the future the money would be made back

Low Risk: Capital Protected Funds

I could live with a 5-10% loss in a really bad year if I could feel it was pretty sure I would make it back

Low-Medium Risk: Heavy use of cash and bonds,35% could be a mix of equitites, property and alternatives 

I could cope with a loss of 20-30% in a really bad year. These things happen. Long term I should make a profit. 

Medium Risk: Around 65% of the portfolio could be in equities, property and alternatives. The balance should be in lower risk asset classes like cash and fixed interest.

I could cope with a loss of 30-40% in a really bad year. I am comfortable taking risks and I realise this may result in losses. My thinking is very long term.

Medium-High risk: A diversified portfolio of equities, property and alternatives, with very limited use of lower risk asset classes.

I am looking to maximise returns. I realise that if things go wrong losses could significantly exceed 40% and may not be recoverable in any reasonable time.

High Risk: A portfolio dominated by equities. Considerable exposure to emerging markets. Possible use of geared investments.

I am looking to maximise returns, and in pursuit of this I am willing to risk very large losses that may in some instance not be recoverable. 

Very High Risk: Significant use of gearing. Heavy use of emerging markets equities and smaller company equities.

Different asset classes

Please note that Mercer does not guarantee the above loss limits. In a given year markets could fall further than indicated above.

  • The information contained in this website is for information purposes only. It should not be taken in any way as advice. It should not be relied upon as an offer to purchase or sell any of the products that are discussed.
  • The value of investments can go down as well as up.
  • Investments or products mentioned on this site may or may not be suitable for you.
  • Before investing or purchasing any product you should always seek independent financial advice. Mercer can provide independent financial advice if required.

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