Stock market investment can offer everyone real opportunities to achieve goals that would otherwise be unobtainable. However, it is important to understand that returns above those offered by a regular savings account involve a level of financial risk. This article takes you step by step though an investment process to achieve a financial objective, while minimising investment risk.
1. Define your financial objective
Goals are general aspirations, whereas objectives are measurable and have a defined timeframe within which they must be achieved.
For example, your financial goal may be to buy a boat that you can sail round the world when you retire. Your financial objective is more specific and could be to build a capital sum of £220k, to purchase the boat, within a period of 12 years.
Note that, to take advantage of long term trends, you should hold stock market investments for a minimum of five years and preferably ten years or more.
So, write down your target amount and target date.
2. Calculate the investment return you will need
Now you have defined your destination, you need to understand your starting point. So, decide if you are going to invest a lump sum and / or make regular investments.
Next, calculate the investment return needed to grow your investment amount, to reach your target amount, within the agreed timescale. To help you with this you can access our free calculator here.
Continuing with the example of purchasing a boat, you might decide to invest a lump sum of £100k for 12 years. To reach the target of £220k, the calculator shows that you will need to achieve a return of 6.8% above inflation.
3. Assess your willingness to take financial risk
You can use a short psychometric questionnaire to assess your willingness to take financial risk, various examples of which can be found online. The output from the questionnaire is typically a risk rating, for example between 1 and 10, with 1 being the most cautious and 10 being the most adventurous. This rating is commonly known as your Attitude To Risk (ATR).
4. Analyse your capacity to absorb financial loss
You may have an adventurous risk rating, but be unable to withstand the possible level of financial loss associated with that rating. Let’s use our example from part 1 and assume the boat is a luxury purchase. A loss of 20% would mean you would not be able to buy the boat you wanted, but you could still maintain a comfortable lifestyle in retirement. Conversely, if you were investing your only source of retirement funds, losing 20% could be seriously detremental to your standard of living.
5. Understand Investment Risk Ratings
We calculated the return needed to achieve your financial objective. But how do you know which investments are most likely to provide this return?
First, we need to understand a little bit about investment risk. Investment volatility is the amount by which the value of an investment varies over time. Higher volatility investments are considered to be more risky, but present the opportunity for greater returns over time. Investing in the shares of a single company is considered high risk, because if that company fails you will lose your entire investment.
A fund manager will invest in a large number of companies and strive to ensure that the growth of one company does not align with the growth of the other companies within the fund. As a trivial example, the fund manager could invest in an umbrella company and an icecream company, so that profits can be made irrespective of the weather. This process of investing in uncorralted companies is termed diversification.
5.1: Asset Classes
Investments are categorised by ‘asset class’. Typical asset classes, in order of low risk to high risk are: UK Gilts, Corporate Bonds, UK equities (shares), Emerging market equities and Commodities (e.g. oil, gold). To keep things simple, we will assume that a single investment fund only makes investments within one asset class. For example, a UK equity fund would only invest in the shares of uk companies.
Managers create investment portfolios with a specified level of risk, by allocating a proportion of the overall investment to each asset class. For example, a low risk portfolio would invest a high proportion in UK Gilts and Corporate Bond funds, whereas a high risk portfolio would invest a higher proportion in emerging market equity and commodity funds. Portfolios can be created to align with the risk ratings generated by the risk profiler.
Risk rating agencies use sophisticated modelling techniques to predict the most probable returns for each risked rated portfolio. In our boat example we calculated that we need a return of 6.8%, so we would look for a risk rating with at least a 50% probability of achieving this.
Please note, that nothing in this article constitutes investment or financial advice.