The Risk vs. Reward Dilemma: How Should You Invest?
Every financial decision carries some level of risk. The challenge is knowing which risks to take and whether the potential reward justifies them. Yet, how do you balance risk and reward?
In this article, our financial planners explain the nature of risk and reward, how they relate to each other, and how to navigate the two in light of your unique financial goals, needs and circumstances.
What is “Risk”?
Most simply, risk (in financial terms) refers to the possibility of losing money – some or all – after committing it to an asset (e.g. shares).
Many people think of market risk when they think about risk. Here, your investment could move in value due to various factors. For instance, shares you bought might suddenly drop 25% due to a geopolitical event, such as the outbreak of war.
However, risk is a broader concept in financial planning. In particular:
- Inflation risk. As the cost of living rises, the “spending power” of a single pound (£) falls. Unless your returns keep up with the price level, they lose their real value.
- Credit risk. If you lend money to a borrower, there is a chance they may not repay you. For example, buying a corporate bond could result in delayed/missed payments to you (the investor) if the company underperforms or goes bust.
- Liquidity risk. How quickly could you get your money out of an investment if you suddenly need it? An “illiquid” investment is one which is difficult to convert into cash. A common example is property (e.g. a Buy to Let).
- Interest rate risk. If interest rates change over time, this could affect the value of your investments. For instance, if the base rate goes up, existing bonds in your portfolio may fall in value. This is because newly issued bonds in the market are likely to offer better rates to other investors, reducing the appeal of those you hold.
What is “Reward”?
Reward is the financial benefit you stand to gain from an investment. An intuitive form of reward is the capital gain. This occurs when you sell an investment (e.g. shares) for a higher price than you originally paid for it.
Another potential reward is dividends. These are handed out by companies to their investors as a share of the profits. A third reward is interest, which comes from fixed-income assets such as savings and bonds.
Rental income could be another type of reward derived from investments in real estate (e.g. payments from Buy to Let tenants).
As a general rule, the higher the potential reward offered by an investment, the higher the risks involved. Examples include equities (e.g. shares on the London Stock Exchange) and property.
By contrast, lower-risk investments offer greater stability and security but also lower potential returns. Assets in this category typically include cash and UK government bonds (gilts).
Risk Tolerance
Different investors are prepared to take on varying levels of risk. Your “risk profile” might differ from that of friends, family members and colleagues.
What matters is that you recognise your own appetite for market volatility and potential losses, integrating this responsibility into your investment strategy.
Otherwise, you might take on more (or less) risk than you are truly comfortable with. This could lead to impulsive and erratic investment decisions in the future, undermining your goals.
Several factors can affect an investor’s personal risk tolerance:
- Age. The younger you are, the more comfortable you might be for your investments to fluctuate (if you do not need the money for a while).
- Financial goals. Investors seeking maximum long-term growth might want to lean their portfolio towards “higher-risk” investments, such as equities.
- Personality, values and beliefs. If you place a high value on financial security and predictability, you may not want to take on too much risk.
- Time horizon. The more time you have to invest, the more opportunities you have for your investments to recover from downturns. This can allow for more risk-taking.
These factors can change over time. As such, consider speaking regularly with your financial adviser to keep your portfolio aligned with your goals, circumstances and preferences. The risk taken should always be limited by the capacity to accept losses
How Can I Balance Risk and Reward?
It is important to start with your own attitude to risk. Studies show that emotions play a significant role in investment decisions.
Fear and greed often drive investors to make irrational choices, such as panic selling during downturns or chasing high-risk investments during bull markets.
To mitigate emotional decision-making, investors should:
- Have a well-defined financial plan.
- Set realistic expectations.
- Avoid making impulsive investment decisions based on market hype or fear.
- Consult a financial adviser to develop a strategy tailored to your risk tolerance and goals.
A key part of balancing risk and reward involves “asset allocation”. For instance, if you want to focus on financial stability rather than growth, it may be appropriate to craft a diversified portfolio leaning more heavily towards bonds (e.g. 80:20 split, bonds to equities – please note this is illustrative, not prescriptive, as actual asset allocation depends on attitude towards risk, capacity for Loss, and individual client goals and circumstances.).
By contrast, an investor with a long time horizon and greater risk appetite might want to focus on growth. Here, a diversified asset allocation prioritising equities (e.g. 80:20 split, equities to bonds – again, this is illustrative) may be more appropriate.
Invitation
Balancing risk and reward is a key part of successful investing. It requires careful thought and planning at the outset, as well as ongoing management going forward.
It helps to have an expert by your side to help with this. If you want to ensure you’re taking the right steps to safeguard your financial future, please get in touch.
Please note:
Your capital is at risk. Investments can go down as well as up. Past performance is not indicative of future results. Tax treatment depends on individual circumstances and may change. This content is for information only and not investment advice. Any decision to invest is the reader’s own. Diversification is key to managing risk. Market volatility affects investment values. Inflation erodes savings. Liquidity risks may prevent quick access to funds.
