What is risk?

It’s very common to hear phrases such as “I only like low risk”, “That’s a high risk asset”, “more risk, more return”.

But these are loose and dangerous informal uses of a concept that has fundamental impacts on financial outcomes. It’s worth investing time to think about risk, and risk management more deeply to help formulate your own attitudes toward it.

Top level risk

Risk is the effect of uncertainty on objectives.

The overall objective of money management is to be able to put your hands on the amount of cash you need at every point in the future you need it.

One good way to mitigate this risk in the short term is to get a job. A more strategic way might be to get some training in a career that will be in demand for many decades.

If you want to be financially independent, then you will need some investment assets that you manage over time to deliver the right amount of cash at the right point in time.

The skill in mitigating this top level risk depends on both the amount of capital at your disposal and how you manage it. Clearly, if you have £10m in the bank and a modest lifestyle, you don’t have to do very much at all to avoid running out of money.

On the other hand, if you have £500K and in your late 50s, you will need a well defined, closely managed plan to see you through the following decades.

Types of investment risk

Below this top level risk, there are more specific uncertainties that will inform your investment strategy. There will be future articles on these, because there’s a lot of nuance.

  • Inflation risk. This is the reduction in purchasing power over many decades in the country where you reside. It’s impossible to predict what future inflation will be, but there are investment strategies to help grow your capital in line with future price movements.
  • Total return risk. This is the uncertainty over the total return that you receive from capital over future time periods. Although absolute return is also volatile and impossible to predict, real return (total return minus inflation) is a lot more stable.

Types of spending risk

The other side of the coin from the top level risk is spending. How you choose to exchange cash for goods and services will have a major impact on sustaining this for every future time period following every transaction.

  • Lifestyle risk. Your lifestyle can be summarised as an annual number of pounds that you spend. If this changes wildly from year to year in response to your desires, then you will find it difficult to manage your top level risk of having the right amount of money at the right time.
  • Discretionary risk. Your spend can be divided into discretionary and non-discretionary. The timing (and size) of discretionary purchases can impact the ability of your investment assets to deliver cash in future.

Types of planning risk

The planning process is a critical part of money management. Doing nothing will rarely deliver riches falling from the sky. You need to have some sort of plan, and stick to it, in order to reduce the top level risk of running out of money.

There are different components of planning risk.

  • Forecasting risk. Your planning models will need to make some rudimentary assumptions about the future. Rates of return, new contributions, future inflation, tax rules, state pension etc. Deviations between assumptions and actuals has the potential to increase or decrease the outlook for the remaining period of your life.
  • Platform risk. You can’t invest without some sort of platform and/or fund to transact through. They are custodians of your future and if your money disappears, it will be very detrimental to your financial health (and probably physical health also). Being very careful about selecting regulated companies and mainstream products will minimise the risk. Quite simply, if you do not understand how the platform works, you are increasing your long term risk.

This list is not exhaustive, and each item has many sub bullets that can be listed. Future blog posts will attempt to flesh them out.

You can see that risk is quite a complicated subject. If someone recommends a “low risk investment” to you, you really need to break it down and assess what that actually means within this cocktail of different risks.

Read more on this topic . . .


Disclaimer

I am not your financial adviser.

The information in this post relates to my financial journey. It may or may not be relevant to your own. You need to make your own decisions on your own financial strategy.

Do not buy or sell anything based solely on what you read.