Risk: what does it really mean?

27 Sep Risk: what does it really mean?

A friend of mine told me a story about his family summer holiday. They spent some time at a waterpark in the Algarve area of Portugal.

While they were at the park, his daughter wouldn’t go on some of the slides. ‘They look quite scary, and I might fall’ she said. My friend, not wanting his daughter to miss out on the experience, tried to persuade her to give it a go. He told her the rides were safe by pointing out the various safety measures and the fact there were lots of people her age going on them. But the girl wouldn’t budge.

What’s the point of this and what’s it got to do with investing? Well, the point is, risk is very personal. Our perception and understanding of risk is unique, regardless of what our peers may or may not do. To my friend, the risk is his daughter will miss out on a thrilling experience. To his daughter, it’s falling off the slide! It didn’t matter to her that it’s an unlikely risk.

Every investment involves some level of risk, a degree of uncertainty and potential financial loss. Therefore, each investor needs to pay attention to what level of risk they are willing and able to take.

There are two key aspects of risk in that statement.

The first is known as risk tolerance. This is an investor’s reasoned willingness to take risk in the long term. As someone once told me, it’s a measure of how much risk an investor can stomach before they start to lose sleep. Risk tolerance is deeply ingrained in our psyche. It has very little to do with how much money we have.

The second is risk capacity, which is a measure of the level of risk that an investor is able to take. This is the level of risk that will have a materially negative impact on your lifestyle. In other words, how much money can you afford to lose before you face financial ruin? Risk capability relates to the level of our wealth in relation to our ability to meet our future goals and aspirations.

This distinction is vital because the risk investors are willing to take, may not be risk they are able to take.

Often there’s a major conflict between the risk an investor is able to take and the risk they are willing to take in order to meet their goals. This is where a delicate compromise is required. Take more risk than an investor is willing to and you end up with someone who’s constantly worried about the ups and downs of the investment market.

Sadly, far too many investors ignore their own risk tolerance and capacity and instead try to shoot the lights out with their portfolios. They end up taking more risk than they’re comfortable with. When the risk materialises, they succumb to their fears and sell.

This is a far cry from what investing should be. At Tandem, we do what we hope is a thorough job of understanding your risk tolerance by using a psychometric test and having extensive discussions on the subject. But we don’t stop there. Our in-depth financial analysis takes account of your current assets and future goals so we can quantify the level of risk you are able to take. The result is a much better investment experience and hopefully no sleepless nights.