What Is Attitude to Risk?

If you have ever spoken to a financial adviser about investing, you may have been asked about your attitude to risk.

It sounds like a straightforward question.

How comfortable are you with the possibility that the value of your investments could rise and fall, sometimes significantly?

This is part of what is meant by your “attitude to risk”.

The difficulty is that most people don't naturally think of themselves as cautious, moderate or adventurous investors. Even if they do, those words can mean different things to different people.

It is also relatively easy to say you are comfortable with investments rising and falling when markets are calm.

It can feel very different when it is your money that is falling in value.

What does attitude to risk actually mean?

Attitude to risk is essentially about how you feel about the uncertainty that comes with investing, including the possibility of losing money.

The Financial Conduct Authority describes it as a client's “emotive response to taking investment risk”.

In simpler terms, how does taking investment risk make you feel?

That matters because investment returns are uncertain.

The value of investments can rise and fall. Sometimes those movements are relatively small. At other times, particularly during a significant market downturn, they can be uncomfortable.

Imagine investing £100,000 and seeing its value fall to £80,000.

You don't know whether £80,000 is as far as it will fall. It might start rising again. It might remain around that level for some time. It could fall further.

How would you feel?

More importantly, what would you be tempted to do?

That second question is an important part of understanding attitude to risk.

Understanding a market fall and experiencing one are different things

Someone can understand perfectly well that stock markets sometimes fall significantly.

They might have read about previous stock market crashes or looked at historical charts showing examples of major stock markets falling sharply and subsequently recovering.

Knowing this doesn't necessarily make the next one comfortable.

When markets are falling sharply, you don't experience them with the benefit of hindsight.

Historical charts show us what happened afterwards. When you are living through a downturn, you don't know whether the worst is over or whether markets could fall further.

Instead, you are surrounded by uncertainty.

You might open your pension statement and see that its value has fallen significantly. Turn on the television and people are discussing a crisis. Look online and there are red charts everywhere.

Commentators explain why markets have fallen and offer opinions about what might happen next.

Then comes a question that even experienced investors can find difficult:

What if this time is different?

Investment knowledge and experience don't remove that uncertainty.

They can, however, provide some context for it.

Experience tells us something a questionnaire cannot

Attitude-to-risk questionnaires can be useful.

They provide a structured way of exploring how you think about investment uncertainty and how you believe you might react in different situations.

The limitation is that a questionnaire is partly asking you to predict an emotional response.

If you have never experienced a significant market downturn, how accurately can you know how you will feel during one?

You might genuinely believe that a 20% fall wouldn't bother you too much.

Seeing £100,000 become £80,000 is different.

Seeing £500,000 become £400,000 may feel different again.

The percentage fall is the same. The experience may not be.

This is why a financial adviser shouldn't look at your attitude to risk in isolation. They also need to understand your investment knowledge and experience, your financial circumstances, what the money is for and what a significant fall in value could mean for you.

Someone who has invested through periods of significant market volatility has some experience of how they responded when investment risk became real.

Someone who hasn't experienced that before is relying much more on how they think they might respond.

Neither tells us with certainty what will happen next time.

Feeling frightened isn't the same as being a cautious investor

Being willing to accept investment risk doesn't mean you have to enjoy experiencing it.

The purpose of assessing attitude to risk isn't to find people who won't feel uncomfortable when their investments fall.

Fear is an understandable response to seeing a meaningful amount of your wealth fall in value.

Even experienced investors can question themselves during extreme periods of volatility.

Investment experience doesn't mean looking at a large market fall and feeling completely relaxed about it.

What matters is what happens next.

• Do you recognise the discomfort as something you had anticipated and continue with the investment approach you had agreed?
• Do you start checking your investments every day?
• Do you begin wondering whether you should reduce risk?
• Do you sell investments after they have fallen because doing something feels safer than doing nothing?

This is where attitude to risk becomes more than an abstract discussion about investment losses.

How we feel can influence how we behave.

Behaviour can have a significant effect on long-term investment outcomes.

Selling investments during a market fall can have long-term consequences. If markets subsequently recover, you may not participate fully in that recovery.

Repeatedly moving in and out of markets creates another problem. You have to decide not only when to sell, but when it feels safe enough to invest again.

That second decision can be just as difficult as the first.

This is why one of the principles I come back to is:

A good investment strategy has to survive the investor as well as the market.

Market falls come with a lot of noise

Part of the difficulty is the environment in which investment decisions are made.

A significant market downturn rarely happens quietly.

There are falling charts, breaking news, economic forecasts and opinions about what might happen next. Some of those concerns may be entirely justified. The difficulty is that nobody knows with certainty how events will unfold.

The challenge is working out whether something has genuinely changed that means your investments should be reconsidered, or whether the urge to change them is mainly coming from how uncomfortable the situation feels.

Attitude to risk isn't the same as capacity for loss

There is another question that needs to sit alongside how you feel about investment risk.

What would a fall in value actually mean for your finances?

This is known as your capacity for loss.

Attitude to risk is concerned with your emotional response to investment risk. Capacity for loss considers your financial ability to withstand a fall in value.

You might feel comfortable accepting investment risk but be in a financial position where a significant fall in value could affect the lifestyle you can afford or prevent you from doing something you had planned.

The reverse can also be true.

Someone may have considerable financial resources and therefore a high capacity to withstand a fall in value, while finding investment volatility extremely uncomfortable.

Put simply:

Attitude to risk asks how a loss might make you feel.

Capacity for loss asks what that fall in value might mean for your life and financial plans.

Both matter.

Taking investment risk isn't an objective in itself. There needs to be a reason for taking it.

Equally, avoiding investment risk altogether can bring different risks.

If money needs to support a long-term objective, for example, very low returns may struggle to keep pace with inflation. If prices rise faster than your money grows, that money will gradually buy less.

Risk isn't simply a personality type

This is also why describing somebody as a “cautious investor” or an “adventurous investor” can only take us so far.

Risk doesn't exist separately from what the money is there to do.

Imagine you have money you expect to use towards buying a house relatively soon and a pension that may remain invested for many years.

They have different jobs.

The consequences of a significant fall in value could therefore be very different.

Your attitude to risk matters, but so do the purpose of the money, when it might be needed, your financial circumstances and how much flexibility you have if things don't go according to plan.

This is why I don't think it is helpful to treat attitude to risk as a permanent label attached to somebody.

Risk only really makes sense in context.

The role of a financial adviser when markets become difficult

One benefit of having an ongoing relationship with a financial adviser is having someone who can provide perspective when markets become uncomfortable.

That doesn't mean telling you not to worry. The more useful question is whether anything has changed.

Have your circumstances changed? Has the purpose of the money changed? Does the financial plan need revisiting?

Or are you experiencing the sort of market uncertainty that had already been considered when the investment strategy was put together?

An adviser can't remove that uncertainty or know what markets will do next. They can help you understand whether something genuinely needs to change or whether the discomfort is simply part of the investment risk you had agreed to accept.

Attitude to risk is only one part of the picture

Understanding your attitude to risk matters because investing isn't experienced on a spreadsheet.

It is experienced by a person.

A questionnaire can help start that conversation, but it can't tell us everything.

We also need to understand what the money is for, when it might be needed, what a fall in value would mean for your financial plans, your knowledge and previous investment experience and how you might behave when markets become genuinely uncomfortable.

Nobody can know exactly how they will feel during the next major market downturn.

Even experienced investors can feel fear and uncertainty.

Perhaps the more useful question isn't whether falling markets will make you uncomfortable.

They probably will.

It is whether your investment strategy, financial plan and the support around you are strong enough to help you make good decisions when they do.

Although the content of the article was correct at the time of writing, the accuracy of the information should not be relied upon, as it may have been subject to subsequent tax, legislative or event changes.

Matthew Birkett
Chartered Financial Planner
Birkett Financial Planning