What is a risk assessment and why is it important? To answer these questions we need to understand more about risk. What is "risk" when it comes to money and investing?
At first glance this might seem like a dumb question – surely "risk" is the danger of losing some or all of your hard-earned savings? This is a good working definition of risk for most of us. Losing money – the possibility of your capital growing smaller or your assets ending up worth less – that's financial risk.
This definition, however, doesn't tell us why some investments are riskier than others, and it doesn't help us evaluate risk. Of course, your reaction might be that you simply want to avoid risk altogether, that you're not interested in 'evaluating' it.
This is where things get tricky. Risk-free investments, like bank savings accounts, are associated with a different kind of problem – insufficient growth and poor rates of return. Money in a savings account grows very slowly.
But isn't a slow return better than taking on risk?
While there is no one answer to this question, the fact is that it's very hard for most of us to accumulate enough money for retirement if we only invest in risk-free products. Many risk-free products actually underperform inflation, meaning that our savings are not even keeping up with the cost of living, let alone growing enough to fund retirement.
Risk products, on the other hand, offer the prospect of higher rates of return – but they're not called risk products for nothing; there is also a chance of losing money. This is sometimes called the risk-return tradeoff – potential return rises as risk increases.
So to get the rate of return needed to create an adequate capital base you need to look at risk products. But which products? And how much risk should you take on?
This is where our Risk Quiz comes in. At a high level we want to assess your ability to carry investment risk.
Uncertainty
Before looking at our investment risk assessment in more detail I'd like to introduce the concept of uncertainty.
As we said, financial risk means the danger of losing money. But risk can also be defined as uncertainty of outcome.
If you invest in a fixed deposit – which is really a savings account with a fixed rate of interest and an agreed minimum period – you know exactly what you're going to get out at the end of the investment term. The outcome is known. But if you invest in shares the outcome is less certain. At the end of a defined period – especially a shortish period (less than three years) – your money could be worth a lot more… or a lot less.
Your financial capacity to withstand this uncertainty of outcome is one of the main things we try to "measure" with our risk assessment.
Why is this important?
The share market goes up in the long run, but in the short term it bounces around a fair bit. For investors (as opposed to traders), the secret to making money from shares is to stay in the market for the long haul and to exit when market conditions are favourable (not when circumstances dictate).
If you're in a financial position where you are forced to dip into your investment stash quite regularly you continually undermine your savings. In the stock market, this erosion is made much worse if financial circumstances repeatedly force you to exit investments when they're low.
To get returns from risky assets you have to stick to a long-term investment strategy. Sticking with it depends principally on two things – financial resources and attitude.
Of these two, financial resources usually have the bigger impact.
Financial resources matter because they affect your ability to absorb unexpected knocks.
When your financial affairs are properly structured – meaning you have little or no consumption debt, you have an emergency fund, you spend less than you make – then an unforeseen expense does not force you to sell long-term investments.
On the other hand, when your financial resources are stretched to the limit all the time it's very difficult to maintain a long-term investment strategy.
This is why the Franc Risk Quiz focusses on age, income, expenses, debt and assets. Looking at these factors at a high level gives a good indication of your overall financial position – and your ability to stick with a strategy.
You can think of the Risk Quiz as a sort of quick financial health check – if you're in good shape you can take on more risk and hold out for better returns. (Being young also helps because you have more time to recover from financial shocks.)
Of course, attitude is also important. Successful investors keep building their investments through good times and bad and let compounding returns work their magic.
It's important to be realistic about your disposition – if you're a nervous person you might want to take on less risk than your financial situation allows.
Conclusion
Both the correct mental attitude and well-structured finances are necessary to achieve investment goals.
The Franc Risk Quiz gives you a quick and easy way to check your financial health and assess the level of risk you can afford to take.
