Attitude to risk and capacity for loss: 3 things you need to know when investing

Attitude to risk and capacity for loss: 3 things you need to know when investing

Historically, stock markets have shown a long-term upward trend. The 2019 Barclays Equity Gilt Study reveals that £100 invested in cash in 1899 would be worth just over £20,000 in 2019. While that may sound impressive, it also shows that if you had put the money into stocks and shares it would have been worth around £2.7 million in 2019.

The study – which tracked the nominal performance of £100 invested in cash, bonds or equities during the period – also reveals that the stock market outperformed cash in 91% of 10-year periods.

That said, you should always remember that investments go down as well as up. This means investing will always carry risk, and you may receive less than you initially invested.

That’s why financial planners take great care to assess your attitude to risk (ATR), in a bid to ensure your money is not exposed to greater loss potential than you are comfortable with.

It’s not only your ATR though. Another vital consideration is your capacity for loss, which at times could be more important than the amount of risk you’re prepared to tolerate. Read on to discover what the difference is between your ATR and capacity for loss, why they both matter and how a financial planner uses them to find the right investment for you.

Your ATR is the amount of loss you’re prepared to accept to get growth potential

While taking too much risk for your situation can lead to losses, so could not taking enough.

One reason for the latter could be inflation, which is the increasing price of goods and services. If your investment is not keeping up with the rate of inflation because it’s in a lower risk fund, it may decrease in value in real terms.

This might mean that when you come to use your investment later on, it cannot provide the income or standard of living you had initially hoped for.

Typically, the higher the risk the greater the potential returns, which is why some investors are happier to take more risk than others.

Key to a financial planner’s work is to understand the level of risk you are happy to expose your money to. This is then used to identify investments that expose your cash to growth potential while, at the same time, providing possible protection against losses should the markets take a downturn.

Often, your ATR is driven by your personality, the amount of knowledge you have around investing and the length of time you want to invest for. It can also change if your circumstances change.

For example, if you have 5 to 10 years to retirement, you may be more risk averse when investing than if you had 15 to 20 years. Having a regular meeting with your planner allows them to keep up to date with your ATR, and ensure your investments remain appropriate to you.

Your capacity for loss is the amount you could afford to lose if your investments drop

The Financial Conduct Authority (FCA) states that financial planners must consider your financial ability to absorb any fall in the value your investment may experience. It adds that, if a loss your investments make has a detrimental effect on your standard of living, this has to be taken into account when assessing your ATR.

This means the planner has to consider how much risk you can afford to take, over and above the level of risk you might be happy to take. As such, your capacity for loss could influence the level of risk your financial planner is prepared to expose your money to when recommending an investment.

Capacity for loss will depend on your assets, age, liabilities, and expenditure.

Your ATR could be at odds with your capacity for loss

Those who can afford to lose more can typically take more risk if they want to. That said, if they don’t want to take more risk, this should be respected by the planner.

The time ATR and capacity for loss could conflict with each other might be when your ATR is high and your capacity to absorb the financial impact of a downturn is low. You might be very happy to take a lot of investment risk, but your lifestyle might be too adversely affected by a loss. In this situation, a lower capacity for loss will typically take precedence over the higher ATR.

This is because it would be irresponsible to expose you to an increased risk of loss, which could then reduce your standard of living.

A financial planner can ensure the right balance between the two

Your financial planner can help ensure your current investments, or any new ones you are considering, are in line with your current ATR and capacity for loss.

Speaking with your financial planner regularly ensures they can align your ATR with your current situation and ability to absorb a loss. This helps provide you with the peace of mind that your investments are exposed to a level of potential growth that shouldn’t impact on your financial security if the markets take a downturn.

Get in touch

If you would like to discuss your risk profile, capacity for loss or your wealth more generally, please contact us on 0800 434 6337.

Please note:

This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.