Investing nearly always involves taking risk with your money. Whilst risk is an inevitable part of investing money, understanding how much risk you want and need to take is often very complex.
Our understanding of investment risk has come on a long way since a decade or more ago when an investor was likely to be labelled ‘cautious, balanced or adventurous’.
Your experience with an investment adviser today is more likely to involve the use of psychometric questionnaires and various financial scenarios rather than ticking one of three boxes to determine your investment decisions.
Risk is a big issue for the Financial Services Authority (FSA) at the moment.
The FSA regulates the provision of investment advice in the UK and their recent messages suggest a lot of dissatisfaction about how the issue of investment risk is being addressed.
Some of the banks have been found guilty of moving too quickly to investment fund recommendations without taking the time to understand how much risk an investor really should be taking. They have also come under fire for incorrectly lining up funds with investor risk profiles; just because a fund is called ‘cautious’ doesn’t necessarily make it any good for a cautious investor.
One thing that often fuels confusion when it comes to investment risk is the sectors in which various investment funds sit.
The Investment Management Association (IMA) is responsible for maintaining these fund sectors and they have now made a positive change by renaming sectors previously known as Cautious Managed and Balanced Managed.
These sectors are being renamed with a letter from the alphabet (for example, Managed B) which will encourage the investor to dig a little deeper beneath the surface in order to understand what a particular sector means.
This move is not universally popular. Many financial advisers do not like the removal of the traditional sector names, possibly because it will mean more work for them to convince an investor that a sector is a suitable starting place for their risk profile.
Making better investment decisions
We all need to get better when it comes to making decisions with our money, particularly decisions about investing money. In our experience, investors often take too much or too little risk when compared to how they really feel about investment risk and the level of risk they need to take to meet their investment objectives.
This can happen for a number of reasons, although a lack of understanding is common.
If major investment banks can fail to appreciate the degree of risk they are taking with their investments, leading to the global financial crisis, it is easy to see how an individual investor might make unwise investment decisions with their own money.
The names of some investment funds can lull investors into a false sense of security. It is perfectly understandable that an investor in a ‘balanced’ managed fund might expect their money to be invested in a balanced manner. It is not until they take a closer look and realise as much as 85% of their money in riskier equities that the reality of the word ‘balanced’ comes home to roost.
Because investment risk is such a personal thing, it rarely makes sense to rely on these types of fund (what we call multi-asset managed funds) to make important decisions about risk on your behalf. It is a step too far in terms of delegation which can leave you feeling in a suitable investment environment when in truth you are taking entirely the wrong amount of risk with your money.
Taking the right amount of investment risk requires involvement and understanding.
Whilst both of these factors can be time consuming, they are important. The alternative is hoping for the best; when it comes to your money, hope should not be a part of the strategy.
