Managing investment risk
One of the most important things for investors to consider is retaining sufficient cash on deposit that will serve as an emergency fund to meet their short term capital needs. Thereafter, they should retain a cash reserve which will meet any planned expenditure over the next three years that cannot be funded from their income.
If they have surplus capital available after providing for their emergency and cash reserve funds, they can then create an investment portfolio for the medium to long term.
Many investors look at investment risk based on the ownership of equities (shares) alone – then come to the conclusion that investing is too risky!
It is important to understand that investment involves a number of different asset classes. In essence, there are four:
- Fixed Interest / Bonds
- Equities / Shares
In addition, there is a fifth asset class which is referred to as Alternatives. This may contain exposure to commodities such as Gold or other assets which do not fall into the four categories above.
Individual asset classes produce varying returns due to the level of risk associated with the investments held within that class. Almost all investment portfolio’s – regardless of the level of risk applied – will contain a mixture of the five assets classes. The difference is the amount that is invested into each class. This is known as Asset Allocation.
Asset allocation is an essential part of any investment strategy. It aims to balance risk and reward by allocating a portfolio’s assets based on the following factors:
- Risk Tolerance
- Investment Horizon
Why asset allocation is Important
Spreading investments across differing asset classes creates diversification in terms of the overall risk applied to a portfolio and has the potential to smooth out the ups and downs associated with investment.
If someone has a short-term investment horizon they will tend to have more invested in cash and fixed interest, whereas a long term investor would typically have a higher allocation to equities.
In terms of risk tolerance for a long-term investor, if they have an adventurous approach they may see up to 80%+ invested in equities whereas if they have a cautious approach they may have 40%-50% invested in equities.
In summary, by seeking professional advice, investors have the ability to invest their capital in a way that is matched to their risk tolerance threshold and their investment term. On this basis, the concept that investing is too risky can be set aside and real returns that exceed deposit interest rates and inflation can be achieved.
The value of your investments can go down as well as up, so you could get back less than you invested