Factor in the risk when making big decisions about investments

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To feel comfortable with finance, it’s vital to understand ‘risk’ and match placing your money accordingly. Far too many are disappointed because they have not appreciated the factors at work whilst a minority are surprised and possibly confused by their financial success.

The level of financial risk will vary with age, commitments, expectations and other key factors. The American investor Warren Buffett said: “Risk comes from not knowing what you’re doing.”

Financial information is vital. Know not only where money is really going to be placed and what return can be expected but what market forces could change the position as well as the financial strength of the provider.

In almost all cases, consult an independent financial adviser. Just as a solicitor should be a trusted family friend, so an IFA should be your professional in the money world.

Do not be surprised if different members of the same firm need to give advice as individuals now are quite often technically adept in specific sectors and have passed the relevant qualifications set down by the Financial Services Authority.

In practical terms, this means someone with the skills to negotiate mortgages is probably not the same individual who can advise on school fee provision or pension planning.

Rather like your intentions before making a will, consider what proportion of any money to be invested has to be kept totally safe.

At all costs, the capital has to be preserved. This element can then be placed in the lowest risk sector such as a bank or building society deposit account or a Government gilt.

Whilst such money will indeed be safe, it is actually going to lose value. This is because the rate of inflation – 3 per cent on retail prices index excluding mortgages – is higher than the interest paid. Banks and building societies do not have to be so generous with interest rates since they can access cheap loans through the Treasury’s £80bn Funding for Lending scheme.

A basic rate taxpayer needs to earn 3.75 per cent annual interest rate to avoid losing money whilst a higher rate taxpayer needs five per cent and those on the top rate six per cent.

Yet the average interest rate on the 309 cash ISAs has fallen from 2.55 per cent a year ago to just 1.74 per cent today. The highest (Coventry with 2.8 per cent requiring 60 days’ notice) will not keep up with inflation, whilst the best instant access (Cheshire) is even lower, paying 2.5 per cent.

Even with a bank or building society, do not place more than the maximum payout from the Financial Services Compensation Scheme:

n Deposit taking firm: 100 per cent of the first £85,000;

n Investment firm: 100 per cent of the first £50,000;

n Insurance firm: 90 per cent of the claim value without an upper limit and with compulsory insurance claims covered in full;

n Mortgage adviser or arranger: 100 per cent of the first £50,000.

Compensation is within 20 business days if a bank, building society or credit union is involved. Apart from insurance (where compensation is per claim), these limits are per individual.

Check that the limit is not inadvertently exceeded because just one banking licence covers several firms. Bank of Scotland, for instance, has a single deposit-taking licence for its clients but also for AA Financial Services, Aviva, Birmingham Midshires, BM Savings, Halifax, Intelligent Finance and Saga.

If an investment is made with an offshore subsidiary of a building society, the money is no longer guaranteed by the parent body.

Since 1996, there has been no obligation to meet liabilities and compensation depends on individual cases where a society offers a contractual guarantee.

At the other end of the risk spectrum, only invest money you are prepared to lose.

However, whilst higher risk generally brings better returns, some countries or schemes may be sound but advisers have become ultra cautious to save litigation and stay within FSA guidelines.

To attract money to riskier areas, the Inland Revenue gives generous tax incentives, notably:

n Venture Capital Trusts with relief up to 30 per cent on £200,000pa;

n Enterprise Investment Scheme with relief up to 30 per cent on qualifying shares between £500-£1m;

n Seed Enterprise Investment Scheme with up to 50 per cent relief up to £100,000 plus rollover of gains made in 2012/13.

The science fiction writer Ray Bradbury said: “Living at risk is jumping off the cliff and building your wings on the way down.” It is possible to reduce risk in many ways, such as buying assets at a discount (as happens with many investment trusts).

Over the long term, the stock market has handsomely outpaced money on deposit. One key way to cut risk with equities is to buy collectives. An informed broker will use rating agencies to complement their own analytical processes.

Morningstar OBSR and Standard & Poor’s agencies previously used a scale from A to AAA to assess funds. They have now changed to a ‘medal’ approach.

The former rates by gold, silver and bronze whilst the latter adds a top layer ‘platinum’ category.

A broker or adviser should start with a blank piece of paper so that preconceived ideas are not introduced.

Risk is subjective. Charles Stanley brokers recently introduced a ‘capacity for loss’ category, meaning how much could your portfolio fall today before it would have a material impact on your standard of living, whether income or growth.

Age is clearly important. Investing for a baby with two decades ahead before the money is required should mean more risky, volatile stocks can be selected.

The overall performance should be outstanding. However, someone coming up to retirement may require a high income, more stable basis.

Equity clients should appreciate that investments can both rise and fall in value. That is why a portfolio should be managed to reflect the accepted level of personal risk.

It’s vital that regular reviews take place. Trigger points should be set, both to sell if an investment falls to a particular level but possibly when a higher price is reached.

Some of the most successful investors do not become over-greedy but accept a certain higher price, aware that by holding on too long the saving may suddenly collapse.

If any doubts, always ask your adviser/broker. A fund or trust which offers high income, presumably derived from good dividend paying companies, may sound straightforward.

In reality, the manager may be achieving such results from synthetic sources such as derivatives. So long as you know the extra risk this brings, it may be fine.

Combining good advice with balance in a portfolio should ensure a relatively risk-free investment life for your money.