When you hear the word “risk” in relation to investing, your mind might immediately drift towards the negative.
This is somewhat understandable. When your hard-earned wealth is on the line, the last thing you want is to lose it.
Yet, risk in investing isn’t inherently bad. In fact, avoiding it altogether could make it more challenging to achieve your long-term goals.
A recent survey from interactive investor found that 58% of Brits – equating to around 31.4 million people – have a low emotional capacity for risk. This means they’re unwilling to face short-term losses on their investments.
Despite this, 32% of these people (roughly 9 million individuals) have the financial resilience to take on risk but are held back by their emotional capacity, resulting in underinvesting.
Continue reading to discover some of the dangers of being too cautious, and how a balanced approach to risk could help you build your wealth over the long term.
If you don’t take on enough risk, you might find it challenging to achieve your long-term goals
It’s first vital to note that every investment carries some degree of risk. There’s no such thing as a completely risk-free investment, and the value of your assets could fall as well as rise.
Still, the purpose of investing is to grow your wealth over time, and taking on some risk is often necessary to achieve this.
There is a clear relationship between risk and reward. Typically, the greater the risk of an investment, the more significant its potential for long-term growth.
Equities, such as company shares, are a good example of this. They can deliver competitive returns over the years, but they are also more likely to fluctuate during periods of uncertainty.
Conversely, lower-risk investments tend to offer more stability, in exchange for more modest returns.
Bonds are considered low-risk investments. When you purchase one, you essentially loan money to the issuer for a set period.
In return, you receive interest payments and your initial capital when the bond matures.
The trade-off is that returns are typically lower compared to equities.
The chart below shows the performance of global equities and bonds between 2001 and 2022, based on the historical annual total return of several key indices.
Source: Vanguard
As you can see, equity market returns were far more volatile than global bonds over this period, the latter of which have more predictable returns.
Still, global equities have outperformed bonds in 16 of the 21 years listed.
If you had invested solely in typically lower-risk bonds, you might find it challenging to achieve your long-term goals, such as securing a comfortable lifestyle in retirement.
Of course, placing all your wealth in equities would have potentially meant that the overall value of your portfolio would have fallen during the decline of 2008.
This is why diversification, which involves spreading your investments across various sectors, asset classes, and geographical areas, is so important.
A typical approach is the “60/40 split”, where 60% of your holdings are in equities and 40% are in bonds.
This could allow you to benefit from the potential growth of equities while creating a buffer with bonds if markets do decline.
It’s vital to establish a comprehensive risk profile before you invest
While it might be prudent to take on some risk, it’s crucial to strike the right balance between risk and reward.
To do so, you should ensure that you understand your circumstances and how much risk you’re willing to accept.
You can start by reviewing your investment time frame. Ideally, you should always invest with at least a five-year time frame, as this gives markets time to smooth out short-term volatility.
For long-term objectives, such as retirement, you may be able to take on more risk, as you have the time to ride out downturns and benefit from potential growth.
Your goals will also affect the levels of risk that are suitable for you. For instance, if your pension is already on track to provide you with a comfortable retirement income, you might be in a better position to take on more risk.
In contrast, if you’re relying on investments to cover essential living costs, you may benefit more from caution.
It’s also essential to account for your wider financial situation. If you have a strong safety net, including an emergency fund and financial protection, you may be able to withstand more volatility without affecting your living standard.
Read more: Why you should always keep an emergency fund, especially in later life
A more cautious strategy may be more appropriate if you have less savings for a rainy day.
You should also take the time to review your tolerance for risk. Everyone will react differently to uncertainty, and a period of downturn might make you react emotionally.
In this case, you could make decisions based on fear rather than logic and sell your holdings. This might only serve to crystallise your losses, harming the overall value of your portfolio.
Even if, after building a risk profile, you find that you can afford to take on more risk, a steadier approach might be wiser if you feel less able to deal with market volatility.
A financial planner could help you build a balanced portfolio
Of course, even though taking on risk to accumulate long-term wealth can be beneficial, this can be easier said than done.
The emotional difficulties of seeing the value of your investments fluctuate could mean you make knee-jerk reactions that don’t align with your investment plan.
Moreover, “risk aversion” is a cognitive bias that means you feel the pain of loss twice as strongly as the pleasure of an equivalent gain.
This could mean you become too risk-averse and fail to achieve growth that helps you secure your long-term goals.
This is where a financial planner can be highly beneficial.
We could help you assess your financial circumstances, goals for the future, and tolerance for risk. Then, we could support you in developing a strategy that suits you.
This could involve building a portfolio that contains both higher- and lower-risk investments, ensuring you remain calm when markets are uncertain.
Most importantly, we could offer some much-needed confidence by helping you to focus on the bigger picture.
To find out more, please contact us by email at info@investmentsense.co.uk or call 0115 933 8433.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
All information is correct at the time of writing and is subject to change in the future.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
