Risk, reward, volatility & capacity for loss

When we speak to our clients about their investments, savings and retirement planning, we often talk about risk, reward and volatility.

We also always need to take into account the capacity an investor has for loss.

I think these items go hand in hand with each other.

It isn’t really possible to get reward without some degree of risk and volatility. And you shouldn’t really invest anyway unless you have and understand your capacity for loss.

The danger of this blog is it could seem to put the emphasis on the negative; risk, volatility and loss are all pretty negative words to the average human being but they are vitally important concepts in investments.

Risk for me is a descriptive word that examines the chances or otherwise of achieving a desired outcome. This is why it is so important to have very specific Financial Planning goals when investing money.

It simply isn’t good enough to have a goal that says “I want my money to grow in value” or “I want to achieve income from my invested funds”. Goals and objectives should be SMART (specific, measurable, achievable, realistic and time-bound).

Risk then can become a description of the chance or otherwise of achieving those goals.

Volatility on the other hand describes the way in which certain investment assets rise and fall in value over time. It is perfectly natural for example for the price of shares to rise and fall.

We tend to like the former and we tend to dislike the latter. But let me repeat it is perfectly normal.

We frown upon those in our profession who claim to consistently be able to time markets in order to avoid the rises and falls of various asset classes.

Someone able to do that would not be providing advice to others; they would be rich beyond belief.

We think it is much better to invest for the long term and have a diverse mix of assets.

Capacity for loss describes the ability to cope with the worst outcome of investing. People sometimes say “I have lost a lot of money on my investment” when actually what they mean is that the value of their investment has fallen.

You only lose money if you cash in the investment when it has fallen in value. Left as it is it might well rise in value again.

Only ever invest if you can cope with the loss of some of your capital or a future reduction in the income that it generates.

Risk comes hand in hand with reward, volatility is normal and losses sometimes happen.

The key thing is to make sure that you are comfortable with the degrees of these that you investments savings and pensions are faced with.

Photo credit: Flickr/zerohero