When deciding whether to invest, it is important that any investment vehicle matches your feelings and preferences in relation to investment risk and return. Hence your asset allocation needs to be commensurate with your attitude to risk. Another key question to ask yourself is: “How comfortable would I be facing a short term loss in order to have the opportunity to make long term gains?” If your answer is that you are not prepared to take any risk whatsoever, then investing in the stock market is not for you.
However, if you are going to invest, you need to be prepared to take some calculated risk in the hope of greater reward. Risk is an implicit aspect to investing: shares can fall, economic conditions can change and companies can experience varying trading fortunes.
The process of deciding what proportion of your investment portfolio should be invested in different types of investment is called ‘asset allocation’.
The four main asset classes are:
These asset classes have different characteristics for risk. When you are young you may want to invest in assets with a higher potential for growth but greater risk, because you have the time to benefit from their long term growth. As you get closer to retirement you may want to choose more conservative investments that are steadier in both risk and return.
There is a wide variety of different asset classes available to invest in and commensurate risks attached to each one. Whilst these implicit risks cannot be avoided, they can be mitigated as part of the overall investment portfolio, by diversifying.
If you put all of your eggs in one basket, you are more vulnerable to risk. Different investments behave in different ways and are subject to different risks. Saving your money in a range of assets helps reduce the loss, should one of your investments suffer a downturn.
There is also a need to diversify within each type of investment. This is especially important in the case of share and bond investing, but can even be true of cash, where the risks are generally lowest. Putting all your money in one deposit account runs the risk that the interest paid on that account will change relative to other accounts. This could mean that the interest you receive is no longer as good as when you originally invested.
It is important to remember that all investments have a degree of risk. Even choosing not to invest is risky. The key is to get the right balance. Most people need a mix of assets in order to achieve their goals. The mix required depends upon individual needs.
By spreading your investments over a wide range of asset classes and different sectors, it is possible to avoid the risk that your portfolio becomes overly reliant on the performance of one particular asset. Key to diversification is selecting assets that behave in different ways.
Some assets are said to be “negatively correlated”, for instance, bonds and property often behave in a contrarian way to equities by offering lower, but less volatile returns. This provides a “safety net” by diversifying many of the risks associated with reliance upon one particular asset. It is also important to diversify across different “styles” of investing- such as growth or value investing as well as across different sizes of companies, different sectors and geographic regions.
Growth stocks are held as investors believe their value is likely to significantly grow over the long term; whereas value shares are held since they are regarded as being cheaper than the intrinsic worth of the companies in which they represent a stake. By mixing styles which can out or under perform under different economic conditions the overall risk rating of the investment portfolio is reduced. Picking the right combination of these depends on your risk profile, so it essential seek professional advise to ensure that your investment portfolio is commensurate with your attitude to investment risk.
The important thing to remember is that with investments, even if your investment goes down, you will only actually make a loss if you cash it in at that time. When you see your investment value fall, this is known as a paper loss as it is not a real loss until you sell.
If you are going to invest, you need to be prepared to take some risk and to see at least some fall in the value of your investment.
Whilst all investments carry an element of risk, the amount of risk you take directly affects any potential returns and losses. Generally speaking, if there is less risk to your investment, your money will grow more slowly and with more risk your investment may fluctuate more.
You should also be aware of currency risk. Currencies, for example sterling, euros, dollars and yen – move in relation to one another. If you are putting your money into investments in another country then their value will move up and down in line with currency changes as well as the normal share-price movements.
Another consideration is the risk of inflation. Inflation means that you will need more money in the future to buy the same things as now. When investing, therefore, beating inflation is an important aim. Investing in cash may not beat inflation over the long term.
The value of investments and the income from them can go down as well as up and you may not get back your original investment. Past performance is not an indication of future performance. Tax benefits may vary as a result of statutory change and their value will depend on individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.