Why you need to plot your lifestyle ambitions before deciding on level of investment risk

By David Lamb CFP™ MCSI

During my three decades in financial planning I have found many investors take far more risk with their money than they need to. This often leads to tears because they have invested in poor performing or risky investments.

Financial advisers need to complete an investment risk analysis before that client invests their money, as part of the regulatory process.

To me, this process is like sticking pins into their clients to find out how much pain they can take and then deliver that pain! The adviser is happy because they have followed the regulatory process and the client is temporarily happy because they will follow the advice.

Most risk analysis processes focus primarily on market risk. This is the possibility of the loss of some of the original capital because the value of investments linked to the stock market can vary and, although the long-term trend tends to be upwards, at any time the market might dip meaning the investment is worth less than was originally invested.

This is probably most investors’ initial concern because of previous experience investing with the wrong risk profile.

But there are other types of risk, including shortfall risk and inflation risk (I will discuss the latter in my next blog).

Shortfall risk is when the amount invested to reach a financial goal at some time in the future may not reach the target amount. Where investments are chosen with no or low risk the returns are likely to be lower or could fall short of the amount targeted.

Knowing how much is enough to give you your desired lifestyle, without the fear of running out of money, will help you determine the returns you need to achieve from your money and therefore how much risk you need to take.

If you are not going to achieve your desired lifestyle with the returns you are earning on your existing investments, you may get closer to your goals if you take a little bit more risk to get those higher returns.

Knowing the returns you need to achieve will help you make an informed decision as to how much risk you should take.

If you are achieving returns above your needs, you can reduce the amount of risk you take with your money.

If you do not know how much is enough, you do not have a financial plan.

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