Investment: What are risk and return?
“Risk” means different things to different people: danger, uncertainty, opportunity or thrill. In the investment world “risk” or “volatility risk” normally means the amount your investment goes up or down compared to the expected growth rate over time. At PageRussell we often call this “uppy-downiness” because we think it makes more sense.
The decision on how much risk you should take with your investments (your risk budget) depends on:
- How much risk you need to take.
- How much risk you can afford to take.
- How much you prefer to take.
Risk required
The risk you need to take can be calculated as the rate of return – that is the amount you need your investments to grow by – to achieve your financial goals.
Risk capacity
The amount of risk you can afford to take is often called your capacity for loss. An example of capacity for loss would be when you need all the money in 12 months. In this example if the stock market crashed by 20% the odds on you making the money back in time are not great. So it is best not to take the risk in the first place.
Risk tolerance
The risk you prefer to take is often called your risk tolerance. Investment risk tolerance is a relative measure, just like judging temperature. You know what you think is hot or cold, but this will be different to what others think. To agree the temperature we need a thermometer. Advisers who rely only on their own judgement of their clients’ tolerance to investment risk will judge their clients risk tolerance relative to their own. This adviser bias is dangerous. To obtain a more scientific measurement of your investment risk tolerance we use the risk profiling services of Finametrica Corporation. You can try out Finametrica’s technology for yourself at www.myrisktolerance.com.
