The Profile your Attitude to Investment Risk Finance Essay

Are you willing to take any risk with the capital you are investing? If yes, how much risk are you prepared to take? How would you feel, if your investment(s) lost 0-10%, 21-30% or even more in the short, medium of long term? How long do you wish to invest for? Are you going to need to access your investment within a year, or do you have a longer time frame mind - i.e. 5 - 10 years or even longer? Do you have a specific investment goal you need to achieve - I.e. school/university fees for your children, holiday of a lifetime etc. These are questions you need to answer, especially if you have never invested before and/or have no idea where to look for assistance in helping you decide how & in what to invest. Before investing any money, you should make it your priority to ensure that you have sufficient funds set aside to protect you (and your family) in the event of an unforeseen emergency, ie redundancy, repairs to your home or car etc. Typically you should have the equivalent of 3 - 6 months of your total outgoings, including any mortgage/credit commitments, household bills, food, travel/motoring costs etc, set aside in an Easy/Instant Access account with a bank or building society. If this isn't the case, you should make this your priority.

What is Attitude to Investment Risk?

Before investing any money, be that by way of monthly payments and/or a lump sum(s) it is important that in addition to your current financial situation, you have a clear understanding of your Attitude to Investment Risk as this will have an impact not only the type of investments you should be considering, but also whether your investment timeframe is realistic. There are two ways to think about investment risk: Your capacity or ability to take risk. This is all about your financial circumstances and goals. If you have more wealth (disposable income) and can invest over the medium to long term (5 - 10 years), you may be more able to accept a higher degree of risk. Your attitude or willingness. This is more of a mental approach. Some people may not be at all comfortable with the thought that their investment can fall in value rather than rise. Others may be prepared to accept a higher degree of risk in exchange for the potential of higher returns.

How to determine your individual Attitude to Investment Risk

There are various to assess your Attitude to Investment Risk. If you don't feel confident enough to invest your money yourself, Financial Advisers can help you develop your risk profile by completing a detailed Factfind to build up a complete picture of your personal & financial situation. The Factfind should also include an Attitude to Investment Risk questionnaire which the advisor will ask you to complete. All of this information will then be used to determine your Attitude to Investment Risk and the Advisor will use this to advise on the most suitable investments for your money. It is important that you ask any prospective Financial Adviser about his/her investment experience and qualifications. "At one end of the scale are independent advisers, who should consider all product types in the market. At the other end will be those offering "simplified", or "basic", advice. Consumers should be aware that these are essentially sales-driven advisers, usually selling just one company's products and often working for a large organisation, such as a bank. Here, advisers won't take a close look at the customer's financial circumstances but will just be giving basic advice about a simple product." (Simon, 2012) You can find a Financial Advisor near to you through Unbiased.co.uk. You should also check that an advisor is registered to give investment advice by checking their details on the Financial Services Authority (FSA) Register. Further information about choosing a Financial Advisor and useful information about Savings & Investments can also be found on the FSA's MoneyMadeClear website. If you intend to research your investments options yourself, it is just as important that you determine your Attitude to Investment Risk and do so honestly and objectively. You can use an online questionnaire, known as a Risk Profiler to do this. The questionnaire consists of a series of short statements, each of which is followed by a scale where you indicate the extent to which you agree or disagree with the statement. In January 2011 the FSA produced a paper on risk & suitability. A key point in this FSA report was that "assessing suitability is not just about the risk a customer is willing to take but must also take into account the client's capacity for loss and their objectives and circumstances." (Loosemoore,2011) Although the wording of the questions may vary between Risk Profiler Tools, in the main, the questions are based on the Alistair Byrne & David Blake Risk Profiling Questionnaire. When using a Risk Profiler tool, it is important to bear in mind that the questions have been designed according to the established principles of psychometrics, that is, the science of measuring individuals' attitudes. This means, however, that these questionnaires do miss the personal questions that a financial advisor would ask you during the course of your meeting. Risk Profiler Tools are also unable to take into account any assets and investments that you may already have, so it is important that you take these into account when answering the questions. There are free to use Risk Profiler tools available online from many leading banks & financial institutions. Whilst complying with professional standards, many people within the Financial Services industry believe these can be biased & direct prospective investors towards the provider's own investment funds, which may be overpriced compared to other similar investments available. An independent Risk Profiler tool may prove a more suitable alternative - i.e. Fina Metrica, which asks more questions and gives a better, independent assessment of your individual risk profile. However, these come at a cost to the user and as a result many people may decide not to use them. This could, however, be a false economy if they give a more unbiased view than the free of use profiling tools. It is important to remember that if you invest without taking professional advice, you will be responsible for your decision to buy, so if the investment turns out to be unsuitable for you, you will have fewer grounds for complaint.

Definition of Attitude to Investment Risk

Once you have answered all the questions, the Risk Profiling tool will indicate the risk profile that matches your Attitude to Investment Risk. Risk Profiles fall into different categories and can vary in number depending on the Risk Profiler tool you have used. The main categories are: Very Cautious (No Risk) - Cautious (Low Risk) - Balanced (Medium Risk) - Adventurous (High Risk) The industry standard descriptions of these Risk categories are as follows:

Very Cautious

Preserving your capital is the most important factor when you consider your savings. This means that you are more likely to restrict your savings (for growth or income needs) to cash deposits, cash ISAs, interest bearing savings accounts and similar products that also offer ready access to your money and are covered under a depositor protection scheme. You understand the effects of inflation on your capital (and any interest received) and how this can reduce the real value of your money over time.

Cautious

The opportunity to achieve reasonable returns (for growth or income needs) is important to you but you want to invest in a way that preserves more of your capital if stockmarkets fall. You may have little or no experience in taking investment risks, but accept this may be necessary to achieve returns potentially equivalent to or higher than those available from cash deposits. You understand that this could involve your capital being invested for five years or more with low to medium exposure to stocks and shares and other more riskier investments. You understand that the value of any investments you make will fluctuate and you might get back less (or more) than you invested (at maturity or earlier).

Balanced

The opportunity to achieve attractive returns (for growth or income needs) is very important to you but you also want to invest in a way that does not expose all of your capital to more riskier investments. You have some experience in taking investment risks and accept this is necessary to achieve potential returns much higher than those available from cash deposits. You understand that this could involve your capital being invested for five years or more with medium to medium high exposure to stocks and shares and other more riskier investments. You understand that the value of any investments you make will fluctuate and you might get back less (or more) than you invested (at maturity or earlier).

Adventurous

You are an experienced investor and are prepared to take on very high levels of investment risk that offer the potential to achieve exceptional returns. This opportunity to achieve exceptional returns (for growth or income needs) is a key priority for you - even in circumstances where it might pose a significant risk to some or all of your underlying capital. You understand that a high-risk investment could involve your capital being invested for five years or more with maximum (up to 100%) exposure to stocks and shares and other more riskier investments. You understand that the value of any investments you make will fluctuate and you might get back much less (or much more) than you invested (at maturity or earlier). It is important that once the Risk Profiler has confirmed your Attitude to Investment Risk category, you are honest with yourself about your own emotional willingness and financial position to accept risk and review how this is reflected in the summary of your relevant Risk category. In some cases it may be approriate to selecting an alternative Risk category. A good way to test your own emotional willingness to handle risk, would be to initially invest with small amounts of money on a monthly basis and increase the overall amount of money you invest based on the returns you achieve and your appetite for handling greater risk. If you feel uncomfortable accepting any amount of risk, then investing might not be suitable for you

Investment Options & Asset Classes

Having ensured that you have a sufficient level of emergency fund set aside, decided on the amount you wish to invest, the timeframe for that investment and confirmed your Attitude to Investment Risk, where and how do you invest and which asset classes should you invest in? It is important that you understand the different types of asset classes, the level of risk for each class and how to spread your investment across the asset classes to create a investment portfolio that matches your Attitude to Investment Risk. There are a number different asset classes to invest in, each of which come with different risks. The four main asset classes are: Cash (low risk), Bonds (low - medium risk), Property (medium risk) and Stocks & Shares (medium - high risk). These can also be sub-divided into further specific categories, ie Commodities, Hedge Funds etc.

Cash

Is perceived as the least risky of the asset classes, but tends to deliver low returns. However, don't think that that there aren't any risks with cash investments - for example the spending power of your money might fall if inflation is higher than the interest rate you receive. This is known as inflation risk. Examples of Cash or Cash equivalent investments are: Cash ISA's, National Savings & Investments (NS&I), fixed notice savings, fixed term investment bonds and high interest savings. In the 2012/13 tax year, the Cash ISA allowance is £5,640 and you can top up your Cash ISA account on an annual basis every tax year. All gains you make from the interest you're paid are free of income and capital gains tax. NS&I is a government backed service for savings and investments, offering a range of products and designed to help people save money. As it's run by the government, it means that 100% of your savings are fully protected, which is much better than the £85,000 that the UK's Financial Services Compensation Scheme (FSCS) provides if your bank goes bust. NS&I offers a range of investment products such as premium bonds and simple cash accounts, children's savings products. They also sell inflation-linked savings certificates. NS&I don't provide market-leading interest rates, on their products as a rule, but if your risk profile is Cautious then this gives the safety you're looking for with your cash and this type of investment could be a good option.

Bond Investments

Examples of Bond investments are: Gilts (government bonds) or Corporate Bonds. When you invest in a Bond, you are lending money to a government or a company in return for a fixed interest rate for a set period of time after which your money is repaid to you. To get the extra reward that these investments can offer, you have to be prepared to accept the risk you could make a loss. However, although Fixed interest investments are are perceived to be the next risk up from cash, they should be less risky than equities. A normal UK government bond (or gilt) could look like this - "Treasury stock, 6%, 2018." This shows the following: ' the issuer' - This is the department that issues the gilt (Treasury) ' the coupon' - This is the rate of interest to be paid (6%) ' the redemption date' - This is when the loan is to be repaid (2018) Corporate bonds are issued by companies these that are looking to raise capital. This type of investment is seen as riskier than government bonds as a rule, as companies have a higher risk of default on debt than governments. Corporate Bonds may offer investors a higher rate of interest for taking on this risk. You may also wish to consider purchasing Bonds from governments or companies around the world. However, bearing in mind the financial difficulties that governments within the Eurozone and companies worldwide have experienced in recent times you need to be aware that investing your inheritance or hard earned cash in this way can be a higher risk and should check that investing this way still matches your Attitude to Investment Risk profile.

Property

Investment in property can consist of a residential Buy To Let property that you own & rent out and/or commercial property.

The three categories of commercial property are:

Retail property - this includes retail warehouses, supermarkets, shopping centres and shops on the high street. Office property - purpose-built for businesses. Industrial property - like warehouses and industrial estates Investing in Buy To Let or commercial property can deliver returns through rental income and capital growth from the possible any increase to the value of the property. However, Buy To Let & commercial properties can stand vacant for long periods of time, resulting in a loss of rental income and the property crash of 2007/08 saw investors lose money, illustrating that investing in property does have risk. Furthermore, investing in property on your own can be expensive and property funds may be more suitable, whereby your funds are managed along with those of other investors by a property fund manager. However, when innvesting in property you should be aware that you may not be able to encash your investment whenever you choose because the land and buildings may not always be easy to sell and during periods when they are not readily saleable the provider may refuse or defer the re-purchase of your units.

Stocks & Shares (Equities)

Is the final asset class and considered the most risky. This is mainly because stock markets around the world can be highly unpredictable as the volatility of the past few years has proved. Investing in UK equities is considered a lower risk than say US equities, while emerging markets are considered the most volatile (such as India, China or Brazil). These markets and the equities within them are viewed as the highest risk as you are investing in less well-known companies and thorough research should be undertaken before considering any investment in this area. The profit from shares comes in two ways, either in dividends and/or capital growth.

Dividends

Companies distribute their profits by dividend payments to shareholders. These payments are usually paid out twice a year. Dividends are more likely to be paid by longer established larger companies - the dividend pay-out will be dependent on how profitable the company is. Smaller companies tend to reinvest their profits to help grow their business so are less likely to pay out a dividend. If a smaller company does manage to successfully expand, the value of your shares could grow and start paying dividends at a later date.

Capital growth

If you sell your shares for more than what you paid for them, this provides you with capital growth i.e. an increase on your initial investment. The price of your shares can go down as well as up and they are affected by internal and external factors. There are two basic types of shares issued by companies that you can purchase:

Ordinary shares

If you purchase ordinary shares, you become a part-owner of the company. Ordinary shares are voting shares, this means you also get a say on matters relating to the company, this could include voting on director's fees or agreeing on a takeover. You are also entitled to a share of the companies' profits once it has met all of its other financial obligations. These are known as dividend, but the payment of dividends are not guaranteed and are made at the company's discretion. There are no guarantees with ordinary shares which is a risk so you may not get any share of the profits and, you're the last in line to be repaid your capital if the company goes out of business.

Preference shares

There are no voting rights for these shares. However, as the name suggests, preference shareholders usually receive a share of the profits before ordinary shareholders, this is usually limited as defined by the issuing company. In addition to this, preference shareholders get paid before ordinary shareholders should the company goes out of business. Preference shares still have risks to your capital investment but not quite so big a risk as ordinary shares but payments are usually less.

Tax on shares

Income from dividends is paid after 10% tax has already deducted, even if you choose to reinvest it or have the dividend paid in shares or cash. Basic-rate taxpayers have no further tax to pay. But if you pay no tax personally, this tax is still deducted and cannot be claimed back. Higher-rate taxpayers have to pay 32.5% of the gross dividend, either by self-assessment or by completing a tax return. Highest rate taxpayers pay an extra 42.5%.

Taxation on selling your shares

Currently you are allowed to make a Capital Gain of £10,600 (2012/13 CGT allowance) before tax is payable.

Creating an Investment Portfolio to match your Attitude to Investment Risk

The principle of risk and return is that the higher the level of risk you are willing to take, the higher the potential return could be. However the reverse side of this principle is that if you take a higher level of risk, the potential for loss also increases. It is therefore important that when investing your money, you ensure that you spread your investment across all four asset classes to minimise the risk and maximise the potential returns. This is known as diversification and your attitude to investment risk will dictate the percentage split of your overall investment into each of the 4 asset classes. You also need to bear in mind how much of your money you would be prepared to lose when determining how much to invest in each asset class. As the saying goes: "Don't put all your eggs into one basket". In addition to the aforementioned points, it is also important to decide whether you are investing for Growth or Income or a combination of the two, as this will also impact on how you diversify your portfolio as you can see from the following charts. An example of a Balanced (Medium Risk) Income Portfolio could look like this:

Asset Class

Percentage Split

Cash 5.00% Government Bonds/Gilts 12.00% Corporate Bonds 20.00% UK Equity 61.00% Overseas Equity 2.00% Property 0.00% As a pie chart, the asset allocation would look like this: Whereas a Balanced (Medium Risk) Growth Portfolio may look like this:

Asset Class

Percentage Split

Cash 5.00% Government Bonds/Gilts 5.00% Corporate Bonds 10.00% UK Equity 47.50% Overseas Equity 25.00% Property 7.50% The corresponding pie chart would look like this: Investing money is a complicated process and not for the faint hearted. Determining your Attitude to Investment Risk from the outset should enable you to ascertain whether or not investing on the whole is the right way forward for you and your inheritance/hard earned savings. It is important that you review your attitude to risk on a regular basis and particularly if your personal circumstances change. That long term investment goal may have to become a medium or even short term goal and it is important that your investment portfolios are rebalanced on an ongoing basis match your Attitude to Investment Risk on an ongoing basis.

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