It's a risky business and the key is understanding that risk

Published on Friday 5 December 2008 19:52

WHEN you're putting together an investment portfolio, understanding risk is essential. You may have thought about your tolerance to risk in the past, possibly in terms of a scale of one to ten, with ten the most risky, but the reality is that not enough people pay attention to risk. This is being brought home now as many investors suffer big losses in their investments as a result of the falls in global stock markets. They have held too much of their money in equities, rather than diversifyi

The financial services industry must take its fair share of the blame for this. The focus in much of the industry is on selling investment products rather than constructing sensible investment portfolios, and many of these products invest in the equity markets. The late 1990s and the "technology boom" is the obvious example of this, where the industry was busy persuading investors to buy technology funds, but in more recent times we have seen that again with funds investing in China, commodities and even with financials funds.

The industry is also keen to extol the virtues of past performance. It is much easier to sell a product after it has performed well, and again technology, China, commodities and financials funds are just a few examples of where investors tend to jump on the bandwagon just as it runs out of steam.

Past performance can also be seen to impact upon investment decisions. Risk is subjective, and an individual's attitude to risk can vary depending on how well their investments are performing. When investments are performing well, there is a tendency to downplay the risks and when they are performing poorly, to assume them to be much greater than they actually are.

For most investors, the importance of risk is an understanding of how much they are prepared to lose. It is much easier to quantify risk if you have some financial parameters to work within. For example, if the investor knows that the maximum return over a given period is likely to be X and the maximum loss is likely to be Y, they can quickly determine whether this fits within both their performance expectations and tolerance to risk.

Most of us accept that to achieve higher returns over the longer term we need to take some degree of risk. However, more risk does not automatically mean higher returns. The challenge is to make sure that any risk you take has the potential to reward you with the highest return commensurate with the level of risk taken.

While a cautious investor may favour more in cash and fixed-interest securities, they could improve the prospects for longer-term returns, and reduce the risk of relying on fewer asset classes, by investing in, say, commercial property and equities as well, in the right proportions.

On the other hand, a more aggressive investor should also hold cash for liquidity and could benefit from the diversification offered by fixed-interest securities, commercial property and other asset classes.

By focusing on risk, and more particularly on managing risk, you can reduce many of the emotional highs and lows often associated with investing and achieve more consistent returns and less sleepless nights.

• Graeme Lind is a wealth adviser at Towry Law in Edinburgh