Risk, Perception and the Investment Process

Understanding risk and the process of investing is critical for investors in order to achieve their investment goals. Put simply, the investment process generally starts with the investor assessing his/her current financial situation, determining the investment goals and establishing a plan to achieve them.

The plan to achieve these investment goals, amongst others, will primarily involve determining and/or forecasting the future savings levels of that person, as well as devising an investment strategy and a risk management policy. Given the fact that investment outcomes, particularly over the short-term, are uncertain, it is important that part of the plan should include a proviso for it to be periodically reviewed as well as the progress being made towards achieving the goals.

It hence comes as no surprise that for a given financial goal, there is a link between the required savings level and the different levels of investment return. The higher the investment return, the lower the required savings level would be and vice-versa. Investors must periodically ensure that they review the investment strategy and policy and would be able to alter/amend the savings level and/or the investment strategy over a pre-defined period of time so as to increase the likelihood of achieving the financial goals.

In most cases, the goals will be expressed as “achieving a particular level of assets at a future date (e.g. retirement)”. Some investors would prefer the goals to be quantified in monetary terms, such as X amount of Euros or US Dollars whilst others would prefer to define the strategy as “achieving a particular level of income each year throughout retirement”.

There is also a link between the investment return and the investment strategy (mix of cash, bonds, property and shares). The investment strategy is: the concoction decided upon by investors and asset managers alike relating to a portfolio comprising of cash, bonds, property and shares to achieve the set targets each year, and the risk measured to make sure that the investment is successful.

When investors put money to work by investing, they would be theoretically putting their money ‘at risk’, even if such monies are placed in a simple bank account. The greatest challenge is to be familiar with and aware of investment risk and what action needs to be taken to manage the potential consequences of the risks being undertaken through the mix of underlying investments. Ideally, this strategy is decided prior to investing.

The term ‘risk’ could be interpreted differently by people, and for some, taking on risk is acceptable whilst for others, risk is something to avoid. For investors who are prepared to take on and manage risk, there are a number of potential benefits in the form of higher returns.

Choosing the right level of risk involves understanding one’s ability to deal with risk. It’s also known as an investor’s ideal tolerance risk level (the willingness to take more or less risk than, theoretically speaking, right for him/her). In this instance, we are referring to the risk preference or attitude towards risk an investor is willing to take on. An investor’s attitude towards risk generally determines the type of investments and asset classes they invest in.

Managing the risky element within an investment portfolio is critical to achieving investment goals. Leaving risky exposure unmanaged is surely, in the long run, detrimental to overall performance and achieving the financial goals, and may ultimately result in an investor needing to save more or having less to spend.