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Risk and reward

Most people think that a high risk investment is one that is worth £10,000 today but could be only £8,000 next year, and that a low risk one is one where that £10,000 will be £10,100 next year, without fail.

This is however only half the story. What matters is the likely real return (which is the return after allowing for inflation).

Imagine that inflation is 3% a year, and that you can get 5% interest on a secure deposit (4% net after tax).

That £10,000 grows to £10,500, but because of inflation you have only made £100. This is secure, but is not going to provide a retirement nest egg.

(£10,000 increased by 5% is £10,500. Less £100 tax is £10,400. But inflation of 3% means that you need £10,300 to maintain the equivalent of £10,000. The result is a net gain of £100).

Now imagine the same scenario but this time you are going to invest in an area that has an element of risk.

While in any one year the risk of the loss may be too great to take (you need the capital to buy that house), if you are able to leave your money for a long time (5 years+) the good years may outweigh the bad.

The essence of risk is that you have to balance the possibility of short term loss against that of long term gain, and that reducing or removing the risk of short term loss can only ever be done by accepting limited growth. When comparing Banks and Building Societies with the stock market, investments do not offer the same security of capital which is afforded to bank and building society deposits.

Part of our role as a financial adviser is to help you determine your attitude to risk, and help select investments that will meet your needs.

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