How much money are you happy to lose?
“Well none obviously” I hear you say. But is that actually the case?
This is a really important question, and one that we spend a lot of time on with our clients, helping them to answer it. It is really important because it helps you clarify how much risk you are willing to take with your money in return for different levels of reward. Let us explain…
When we start working with a client who is saving or investing money, whether it is to build up a nest egg, grow an existing portfolio of investment assets or indeed plan for their retirement, gaining clarity around your investment objectives is the first step. When do you want this money to be available and what must this money be able to do for you? We’ll take an example…
Sean and Mary
We had clients recently (we’ll call them Sean and Mary) who had a sum of money to invest as a result of an inheritance. We spoke at some length about their future lifestyle goals and dreams and throughout our discussion, one goal kept coming to the surface. When they retire in about 12 years time, they want to escape from Ireland for a few months every winter and live somewhere warmer. They want their own place in the sun.
So now we had both a timeframe (12 years) and an objective (a holiday home). The question that they now started asking was what size / type / quality of holiday home could they afford? And so our conversation turned to risk and reward.
Attitude to risk
We explained that we needed to understand their attitude to risk. Are they people who would invest this money and take no notice of movements in stock markets and other assets over the next 12 years, even where there were significant swings? Or instead, are they likely to lie awake at night worrying if the value of their pot of money decreases at all, even just in the short-term? Of course relatively few people are at either extreme end of the risk spectrum, most are somewhere in between. It’s our job to find out where you are on this spectrum.
Capacity for risk
We also look to establish your capacity for risk. This is effectively your financial firepower in terms of taking risk, or how much you can afford to lose. If your financial goals are out of reach or significantly threatened should you lose some or all of your money, then you have very low capacity for risk. If you have lots of other financial assets and losing some or all of your money won’t make a material difference to you, then you have a high capacity for loss.
Risk v reward
Once we understand your attitude and capacity for risk, this leads us to a conversation about building the right investment portfolio for you. Because risk and reward are inextricably linked. If you can’t take or don’t want risk at all, then maybe your money needs to be on deposit. You will get a very steady return (or at least you should), albeit a very low return. And apart from the impact of inflation, you won’t lose any of your money. But you won’t grow it either.
However if you are comfortable with your portfolio being more volatile and taking swings in value, this offers the opportunity for you to make higher returns. But of course you are now running the risk of losing money (instead of growing it!) and possibly suffering a correction in markets just before you need your money, potentially scuppering your plans. This is the classic risk v reward trade-off.
We can demonstrate how different baskets of assets (cash, bonds, shares, property etc.) can be combined to produce different risk & reward profiles.
Back to Sean and Mary!
Coming back to Sean and Mary, they are actually relatively conservative investors. They don’t want to (and would) worry about their money if there are significant swings in their investment over the next 12 years. They’re happy with only gentle falls in their investment amount from time to time, while recognising that this conservatism will potentially suppress their return. But they are very sure about one thing. They definitely want to afford that place in the sun in 12 years time and have no other means of funding it. They’re happy if the property ends up being a little smaller than they might wish for. But to them this is better than shooting for a palace, but possibly ending up with a cardboard box!
Does your investment portfolio reflect your attitude to risk and your capacity to take it? We’d be delighted to hear from you and help you make sure that you have a risk appropriate portfolio in place.