Managing risk is a core element of investing. And it’s not just about how much risk you might be comfortable taking with your money. It’s also important to understand how much risk you can afford to take. This article explains how the investment professionals manage risk within investment portfolios.

The relationship between risk and return

Risk is a concept we all learn from an early age – we take a risk when we cross the road or try something unfamiliar. It’s the possibility that things will end badly. But taking a risk can also result in a positive outcome. ‘Nothing ventured, nothing gained’ as the saying goes.

Investing your money in stocks and shares carries an element of risk. The higher the risk, the greater the chance you’ll have of  losing some or all of what you put in. However, higher-risk investments also come with the potential for greater returns, making them attractive to the more adventurous among us.

In contrast, lower-risk investments mean you’re less likely to lose money, albeit the potential returns will also be lower.

Risk capacity and risk tolerance are used to determine what level of risk you are comfortable with and can afford to take

How much risk are you comfortable taking?

There are two key concepts when it comes to deciding how much risk you’ll take with your money: risk tolerance and risk capacity.

Risk tolerance is the amount of risk you feel comfortable taking, or the degree of uncertainty you’re prepared to accept in order to achieve a desired outcome. If the thought of losing even a small amount of money during market turbulence makes you feel incredibly uncomfortable, you’re probably towards the cautious end of the risk spectrum.

Unlike risk tolerance, your risk capacity (sometimes called capacity for loss) informs how much risk you can – or, more importantly, can’t – afford to take with your money in order to achieve your goals. This is established using information about your personal and financial circumstances, such as your household income sources, expenditure, assets, liabilities/debts, dependants, the stage of life you’ve reached and your investment timeframe. Your financial planner might also use cash flow modelling to help visualise your plan and demonstrate the impact a sudden loss of income or an unexpected expense can have on your financial situation.

Together, risk capacity and risk tolerance are used to help determine the level of risk you are comfortable and can afford to take, when it comes to investing. Evaluating your personal approach towards risk involves a conversation and a series of questions. It’s very easy for someone to under, or overestimate their risk tolerance, or get an inaccurate calculation of their personal risk capacity. That’s why we’d always recommend appointing a qualified independent professional planner to do it for you.

Your adviser may well use a risk questionnaire to help establish your risk profile

How your financial planner will help you evaluate risk

Financial planners use the detailed personal and financial information they gather from their clients, and the conversations they have with them about risks, to gain a thorough understanding of their client’s willingness and ability to take on risk. Failing to get an accurate assessment of risk tolerance and capacity could lead to an unsuitable recommendation.

Your adviser may well use a risk questionnaire to help establish your risk profile. This consists of a series of questions designed specifically to assess your understanding of risk and how much you’re willing to take. Your responses will inform the overall financial fact find and give a clear picture of the type of investor you are, what you want (and need) your money to do for you, and how much risk you can take along the way.

Taking the right level of risk with your investments

It’s the job of an investment manager to manage risk on behalf of investors. They do this by constructing a range of risk-rated investment portfolios, that suit the needs of investors wherever they are on the risk spectrum.

This gives you some insight into how much risk your portfolio will be exposed to and the return you can expect as a result. Of course, past performance can’t tell the managers what’s going to happen in the future, but it gives them a framework in which to manage the different investment profiles.

Risk-rated portfolios from Amber River

At Amber River, we believe investors should only take the level of risk necessary to deliver the investment returns they need to achieve their desired outcomes. That’s why our IFAs offer a range of risk-rated model portfolios that cover a variety of different investment styles, from passive through to impact investing.

Get in touch

Our Life Landscaping® approach recognises that an effective investment strategy reflects a client’s specific goals, attitude to risk, financial situation and individual circumstances. To speak to one of our team about our risk-rated model portfolios, or to arrange an appointment, call 0800 915 0000, or alternatively use our contact form here.