Should you be taking more or less risk with your investments?

by Jonathan Adams
investment risk

Investing according to the appropriate risk profile for your personal circumstances is arguably the single most important factor in determining if you will achieve your long-term targets or not.

Go to conservative early and stick to relatively sure things and you won’t grow your capital. In fact, if you rely on deposit-protected savings accounts, currently offering a maximum of around 2% interest in the best-case scenario. And usually only on smaller sums of up to several thousand pounds.

Low-risk bonds like gilts won’t do any better with yields at record lows.

gilt yield

Essentially, if you’re not prepared to take on more than the minimum level of risk, the purchasing power of your savings and investments will almost certainly be eroded over the years. Inflation in the UK has historically run at, between 1990 and 2020, an average of around 2.35%.

stats

Source: Statista

But taking on too much risk with your investment portfolio in the pursuit of higher returns can be even more of a disaster than your capital being eroded by low-risk investments and savings products. If you over-expose yourself to market volatility or weigh your portfolio too much towards high risk-high reward opportunities you could blow a gaping hole in the value of your capital if things go wrong.

Just ask investors in the Woodford Equity Income fund. The fund was marketed to retail investors and recommended as a ‘best buy’ by Hargreaves Landsdown, the UK’s largest investment platform. But it was invested in a host of risky and illiquid growth companies that, in retrospect, clearly didn’t have the right profile for retail investors.

If things had gone well, the fund might well have made the kind of market-beating returns manager Woodford made his name for delivering as a star fund manager for Invesco Perpetual. Unfortunately, big investors lost patience with the fund’s poor mid-term performance and when enough pulled their cash, the illiquidity of its holdings meant its administrators had to suspend withdrawals.

The fund was ultimately shut down and the last assets are still in the process of being sold to return money to investors. Depending on when investors bought into the fund, they will have lost between 20% and over 50% of their initial capital invested.

The Woodford Equity Income debacle is an extreme example and the biggest criticism is that the fund wasn’t marketed with the appropriate risk profile. But is also a perfect example of why investors have to also be able to judge risk profile for themselves. And spread risk by not putting too many eggs in one basket.

So just how much risk should you be taking with your investments?

How much investment risk is the right amount for you?

How much risk you could, or should, expose yourself to is very much dependent on your personal financial circumstances and investment goals and timelines. If you are unsure what that means for you, you should always consult with a qualified financial advisor.

But there are some general rules of thumb you can keep in mind.

Should I hold cash savings and how much?

We’ve already mentioned that holding savings in cash inevitably means its purchasing power being eroded over time in the context of the interest rates currently on offer. With the end of the tax year on April 5th rapidly approaching, now is also the time to take advantage of the tax breaks offered by annual ISA and SIPP allowances – £20,000 and £40,000 respectively.

Putting money into an ISA means all interest or returns on investments generated are tax-free for life. Pension investments also come with income tax relief, which rises with your income band.

But with many cash ISA and SIPP products offering only 0.05% interest, up to around 1% in the absolute best-case scenario, it’s highly debatable if it makes sense to hold cash, rather than risk-based investments, in wrappers.

How much cash should be held is a particularly pertinent question as the end of the tax year approaches this time around. The Office for Budget Responsibility estimates British households have built up much more in cash savings over lockdown than is usually the case over a normal year. The estimate is that around £180 billion has been stockpiled in cash. 60% of which is languishing in standard current accounts and often earning a pitiful 0.01% in interest.

Standard financial advice for those in work and not approaching retirement is to hold enough cash in a ‘rainy day fund’ to cover around 3 months of living expenses. Up to 6 six months might be reasonable for those with a family to support and erring on the side of caution.

But more than 6 months of living expenses held in cash would be advised against in most circumstances because it will only lose value over time. Cash savings should be considered a financial buffer – not a savings and investment strategy.

Laith Khalaf, an analyst at investment platform AJ Bell comments:

“It’s definitely prudent to build up a cash buffer to deal with any unexpected costs, particularly in uncertain times. But cash Isa savers may be doing themselves a disservice by holding too much in cash, opening themselves up to inflation risk, and missing out on the higher returns potentially available from investments. While stock market investors need to avoid irrational exuberance, cash savers should be wary of excessive prudence.”

If holding cash is the wrong choice what should I invest in?

While many Brits have built up their cash savings considerably over the past year, many have also taken advantage of extra free time over lockdown to make their first forays into investing.

Short-term trading – how risky is it?

Trading, taking short-term, often leveraged, positions on the movement of individual financial instruments like stocks or indices, has soared in popularity. That trend has been accelerated by the media attention the tens-of-thousands-strong army of retail traders taking on hedge funds, and coordinated online via the subreddit #WallStreetBets, has attracted.

But short-term trading, especially if it is leveraged, is a highly risky business. And very few retail investors prove adept at it. A large majority of retail investors day-trading, as high as 97% according to one academic study published last June, lose money.

This suggests retail investors should probably not consider short-term trading as investing at all, but speculation. It can be a great way to learn about how financial markets work. And a minority of traders to make money – sometimes a lot. But very few. And getting to that point involves a lot of research, learning and practice. Even then, few also succeed in maintaining the kind of iron self-discipline needed to negotiate the pitfalls of short-term trading.

If you are keen to give trading a try, and you might end up being among the minority to succeed in realising consistent returns over the long-term, only do so with money you are prepared to lose. And on the understanding, statistically speaking, you probably will lose it.

Long-term investments

If trading can, for the vast majority of smaller retail investors, be considered speculation rather than investing, what kinds of investments might be more suitable?

Most retail investors have a relatively long-term horizon of at least 10-20 years. The big advantage of investing for the long-term is that you can to a large extent ignore short-term market volatility. Long-term typically refers to investments with a horizon of at least 10 years with a target like funding retirement or school or university fees for children or grandchildren.

Adrian Lowcock of investments company Willis Owen comments on his own long-term approach to investing:

“This longer-term time horizon gives me a different perspective. I can look through the short-term volatility in markets and focus on where the opportunities are for the next 10 to 20 years. It means I can assess the impact of Covid over the longer term, not just the next 6 months and look at where the growth opportunities are.”

For most retail investors, long term investments will be made through funds. The usual rule of thumb is that the further away from retirement an investor is, the more adventurous they can be with their choice of funds. Unless you are a high net worth individual, ‘adventurous’ is still a relative term and investments should still focus on mainstream assets such as listed equities and bonds. However, you can afford to risk more exposure to short-term market volatility and invest in funds that have an allocation to high growth, riskier stocks in sectors like technology and biotech.

Wealthier investors might also consider allocating some of their portfolio, 10% to 20% is typically considered a good rule of thumb, to funds or individual stocks or markets with a higher risk-higher reward profile. For example, venture capital trusts (VCTs), which also come with tax advantages.

VCTs offer investment exposure to promising start-ups which are high risk but can deliver big returns if even a small number of the companies in their portfolios are successful. And it still spreads risk compared to a direct investment in one or two promising start-ups.

Backing promising start-ups directly is also an option and can be done via the EIS and SEIS schemes. EIS and SEIS investments come with attractive tax breaks to encourage private investment in promising young UK start-ups. But the reality is a high percentage of young companies either fail or their growth stalls.

Investing in start-ups directly can, if the company goes on to establish itself, lead to huge returns. Which are also protected from tax via EIS and SEIS. But will also often, a majority of the time, result in losses.

Trying to identify young companies that will go on to thrive can be a hugely rewarding way to invest. But it’s also high risk and not for the large majority of retail investors. If you want to go down that path, only invest money you are prepared to lose as the price to pay for the flip-side of a potentially significant win.

Private equity investments in start-ups and young growth companies, like those via the EIS and SEIS schemes, are also illiquid so you need to be prepared for your capital to be tied up for years and difficult to access should you want to in the interim.



Important
This article is for information purposes only.
Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.
There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.

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