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Understanding risk

An animated video showing the risks of investing in financial assets, and some ideas on how risk can be managed.

 

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The purpose of investing is to grow our assets with a view to meeting some future goal. But we need to do that without exposing ourselves to more risk than we can comfortably bear. Asset allocation is the key tool that we use to achieve this balance.

All investments carry some level of risk, and normally a higher level of short-term risk comes with the benefit of a higher long-term return. It’s one of the core trade-offs of investing life.

By combining equities, bonds and cash in different proportions, we can build portfolios that are designed to deliver a variety of long-term returns. Those portfolios will also carry varying levels of expected risk, or volatility.

More equities in the portfolio will increase the long-term return, but will also expose the portfolio to more short-term risk. More bonds and cash will have the opposite effect.

Each of us has our own individual attitude to risk and our own personal goals. And we all need to understand the relationship between risk and return as it relates to our goals.

Some people are happy to accept the day-to-day fluctuations of markets in return for the potential of higher long-term returns. But others will be less comfortable with the prospect of losing money, and these investors need to accept the likelihood of more modest returns.

For this reason, it might not always be possible to reconcile our goals and our risk appetite. If this is the case, we might have to lower our expectations or raise our contribution levels.

But assuming we do manage to strike the balance – and most of us will - the right mix of assets should provide the right long-term return to help us reach our goals.

Then it’s just a question of reviewing and rebalancing to keep the portfolio on track. We’ll talk more about rebalancing later.

As we approach our investment goal, we need to view risk in a slightly different light. After all, it’s no use setting out a long-term plan, only to find it de-railed by a market setback at the last minute.

We can help to minimise this risk – known as drawdown risk – by raising the portfolio’s exposure to lower-risk assets as the goal approaches. This will reduce the return potential of the portfolio, but by this point most of the ‘heavy lifting’ should have taken place and protecting the gains of previous years becomes more important.

Investment risk information:

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

Other important information:

This video was produced by Vanguard Asset Management, Ltd. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.

If this is to be used on third party websites for an audience of professional investors as the submission suggests I would also include the for professional investors disclaimer at the top.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

© 2018 Vanguard Asset Management, Limited. All rights reserved.