Managing risk and investing efficiently

What you’ll learn:

• Why you need to understand your approach to risk
• How asset allocation can help you manage risk
• Why you shouldn’t base investment decisions on past performance.

Before you begin to examine some of the market risks you could face – such as political, economic and currency risks – you have to think carefully about your own approach to risk.

There are three common types of investor:

• Medium-low: You're likely to be comfortable making investments that may have limited potential for losses in exchange for higher returns. While the possibility of small fluctuations in your wealth doesn’t bother you, you prefer to avoid investments that could fall substantially in value over a long-term investment period. You would be happier with a steadier, lower rate of growth than a higher, more volatile one
• Moderate: You’re comfortable with investments that may lead to fluctuations in the value of your portfolio in exchange for the opportunity to achieve above average increases in your wealth in the long run. You accept that by putting your money into riskier investments with the aim of getting a better return, you could make a loss on the wealth you invest
• Medium-high: You’re prepared to accept regular fluctuations in the value of your portfolio and are willing to take on higher risk in exchange for the opportunity to increase your wealth in the long run. You recognise that this means your money could be subject to significant short-term fluctuations in value, and both the potential for long-term gain and loss are greater.

Find out more about your attitude to risk

Leaving your approach to risk to one side, there are other factors to consider when deciding where to invest. Your time horizon is important. If your investment goal is a long way in the future, you may be prepared to accept a higher level of risk, because if you suffer financial losses, you will have more time to recover your position. If you have a shorter time frame to invest over, you should be considering moving money into safer havens.

If your investments are providing your retirement income, you need to be careful that any falls in your portfolio value do not leave you unable to pay for your basic living expenses.

Once you’ve worked out the level of risk you are prepared to accept, you’ll be better placed to begin choosing a mix of investment types.

Risk management means making sure the investments you choose provide the right kind of balance.

Why asset allocation matters

Asset allocation – the best way to divide your investment money between various asset classes such as cash, bonds, and shares – is crucial when it comes to building any investment portfolio.

As each type of asset will perform differently at various points in time, making sure your asset allocation is diversified can help reduce overall volatility.

If, for example, you put all of your money into just one asset class, you are at much greater risk of losing significant amounts of your savings if something goes wrong, than if you have spread your investment money across several different asset classes.

Deviating from a diversified portfolio is not a good idea unless you know exactly what you are doing and why you are doing it.

Often purchasing one multi-asset class fund – that’s a fund that invests in a range of asset classes rather than just one – is easier than building a diversified portfolio from scratch. When you are considering a fund, look at the fund factsheet and key investor information document (KIID) to see its diversification across asset classes and its risk indicator, which ranges from one (lower risk/potentially lower reward) to seven (higher risk/potentially higher reward).

Diversification won’t wipe away all the risk attached to investments but it can reduce the chances of you losing all your money.

Find out more about diversifying your investments

Past performance cannot predict the future

Investors should be on their guard against making any investment decision based solely on the past performance of a particular company or fund.

While it might be tempting to invest in a fund or company that has previously performed well, there are no guarantees that the same company or fund will go on to deliver such good returns again. The past performance of investments is not a reliable indicator of future returns.

You should research the asset class and sector of any investment you are considering making to see how similar it is to other investments you hold. Investing in a broad range of different investments across different asset classes and sectors will likely help you to achieve a better diversified portfolio. But it’s important to always keep in mind that no matter what steps you take to manage risk, your investments can still fall in value and you may get back less than you invest.