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Investment: Risk versus reward

Though there’s truth in the adage ‘nothing ventured, nothing gained’, it’s important to know your risk profile and balance potential gains with your capacity for losses 

The challenge is ensuring that the risks you take in your investment portfolio will help you achieve your objectives.

When building an investment portfolio, aligning it to your risk profile is essential. But it’s important to remember that your risk attitude is as much about capacity for loss as it is about potential gains.

All too often people overlook investment risk and focus on the potential rewards. What is frequently ignored is that, along with the potential for attractive growth, there is also the possibility of a significant loss.There is perhaps no better example of the perils of taking too much risk than the dot-com bubble of the late 1990s. Back then, technology companies were the darlings of the stock market. Their share prices were soaring and there was no shortage of investors — many of them novices — willing to invest at any value. The mania masked the risks and when the market turned, countless investors faced significant losses.

The challenge is ensuring that the risks you take in your investment portfolio will help you achieve your objectives.

Indeed, risk in finance is no different from risk in business: nothing ventured, nothing gained. The challenge, however, is ensuring that the risks you take in your investment portfolio will help you achieve your objectives while also not exposing you to excessive potential losses. 

This is where a risk profile comes in. A qualified professional such as a financial adviser or a wealth manager can help you identify and build your risk profile. A key element of this profile is to establish your perception of risk and what level of risk you’re prepared to take to achieve your financial ambitions. 

Seasoned investors will have a clearer idea of the nature of risk and the level of losses they can sustain. In particular, they may know how investment valuations will fluctuate according to market conditions and the need to calibrate the level of risk according to the investment’s time horizon and objective. 

Novice investors, on the other hand, tend to be more wary about any potential downturn in the markets and so tend to be more risk averse. This doesn’t mean that they are unwilling to take greater risk. A risk profile can help them to better understand how much risk they can take in their portfolio.

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Many wealth managers will establish your risk profile by using questionnaires that aim to establish three factors: objectives, risk tolerance and capacity. The investment objectives may be long term, such as funding a pension, or more short term, such as paying school fees, and will affect how much risk is required to achieve that objective. Tolerance is the level of risk that you’re comfortable with, while capacity refers to what extent you can bear a financial loss.

Market volatility is a necessary part of the business of investing, but the downturns are often covered by the returns during healthier market periods, especially over medium to long-term investments, and this process will also help to explain the benefits of longer term investing. A critical aspect of this conversation is the time horizon. A short-term horizon is less likely to recover from any temporary losses, so it might require a more conservative approach. Conversely, a long-term investment, such as a pension, would allow more time to overcome temporary downturns, therefore greater exposure to equities may be suitable. 

Of course, any discussion about this needs also to take into account the possibility of unexpected or life-changing events, such as emigration, terminal illness or early retirement.  

Once your risk profile has been established, a good wealth manager will then take you through an optimal investment strategy based on that profile and your investment objectives. By carrying out this process you should have a greater understanding of your investment portfolio, more realistic expectations of what level of returns can be achieved, and less anxiety in periods of volatility. 

If your financial adviser or wealth manager hasn’t been through this process with you, then you might want to seek a second opinion. 

The writer is head of Quilter Cheviot’s Dubai representative office

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