A “low-risk” approach to managing your wealth might actually involve taking on more risk than you think. Here’s why

What’s the risk of it raining next Tuesday? Even in the height of summer, the chances of us seeing rainfall in the UK next week are likely quite high.

But what’s the impact of that rainfall? Aside from perhaps a few scuppered barbecues, slower road travel, and some rainy wedding photos, the effect it will have on daily life is relatively limited.

Now, think about the risk of a meteor hitting Earth next week. Pretty unlikely, right? But in terms of impact, it could be devastating.

While we might take a coat and an umbrella out with us next week, as a society we don’t tend to think about how we can stop rainfall.

But when it comes to a high-impact event like a meteor striking, we invest heavily in monitoring these celestial bodies and finding ways to destroy them should we ever need to.

This is a common approach to the way we manage risk in all areas of our lives. We think about both the likelihood of an event occurring and the potential impact it could have, and then act accordingly to reduce the risk this involves. In essence, we use the available information to find the lowest-risk course of action.

Risk is a crucial part of managing your wealth. It’s important to strike the right balance of risk you take on, so that you can grow your savings over time without overexposing yourself to losses that could derail your progress toward your financial goals.

However, this fear often leads people to exclusively pursue a low-risk strategy. While this might sound sensible, it may involve taking on more risk than you think. You might be busy trying to stop the rainfall, all while a meteor is coming toward you.

So, find out why this is the case with your wealth, what you can do to construct a portfolio with a level of risk that suits you, and how a financial plan can help you mitigate risk in general.

Risk in wealth management often refers to investment risk

When it comes to managing risk with your wealth, the first area you might think of is investing.

It’s true that investing inherently involves risk. When you invest your wealth in stocks, bonds, and other assets while trying to generate returns, you run the risk of your investment falling in value, or even losing the entire sum – if a company you have invested in fails, for example.

Taking on risk with your wealth can feel concerning, especially if it’s not something you’re used to. We often see this when we meet new clients. You might come into your first meeting with us and say, “I don’t want to take on risk because I don’t want to see my investments go down.”

Yet, risk is usually positively correlated to returns; that is, the more risk you take on, the greater returns you could generate over the longer term.

The key is to design a portfolio with the right level of risk for you. That means taking into account your personal tolerance for risk, as well as what sort of returns you would need to generate to give you sufficient funds for achieving your goals.

This is a delicate balance.

Exposing your money to risk through investing can offer the potential to grow its value over time. On the other hand, taking on more risk than you can tolerate or afford is potentially dangerous, as you could end up with less than you initially invested.

But, employing an approach of too little investment risk can be equally detrimental, in large part because there may be other risks you have not considered. Indeed, if you spent your time trying to prevent the rain and missed the potential danger of a meteor, that wouldn’t be the risk mitigation strategy that you initially thought.

Not taking on enough investment risk means taking on risk elsewhere

Having a low risk tolerance is not inherently bad. Avoiding higher-risk investments and choosing low-risk options can be a positive, if it means targeting returns that suit your needs without the worry of seeing those investments fall in value.

However, this definition of “low-risk” is not very broad, as it only encompasses investment risk – and this is not the only type of risk you may be taking on.

Think about your reasons for saving and investing your wealth. Among your immediate needs and short- to medium-term goals, one of your longer-term targets is likely to be retirement.

If you’re building wealth for your retirement, or another goal set for 20 to 30 years’ time, it’s highly important to consider “inflation risk” too.

This refers to the eroding effect inflation can have on your wealth. As the cost of goods and services rises over time, your money’s value depreciates in real terms as its spending power is reduced.

You might see the headline inflation figure in the news each month, which the Bank of England (BoE) aims to keep at 2% a year. A small increase of 2% a year may not seem like very much. But, over two or three decades in retirement, it can really add up, as the BoE’s inflation calculator shows.

Had you retired 20 years ago on an income of £40,000 a year, the calculator says you would need £70,067.61 to achieve the same lifestyle in 2024. That’s an increase of 75%.

Over the course of those 20 years, rising prices mean you now need substantially more to maintain your lifestyle. If you exclusively pursue a low-risk investment strategy, you reduce the chances of being able to generate returns that keep up with inflation.

Indeed, this graph demonstrates the percentage of time periods in which stocks and cash have beaten inflation in the period from 1926 to 2022:

Source: Schroders

As you can see, investing in a range of stocks and shares would have consistently given you a greater chance of beating inflation, especially over longer periods. Meanwhile, cash has been less likely to do so.

In turn, this exposes you to what we often refer to as “financial planning risk”. This is the danger of not generating the returns you need to achieve your goals, potentially putting your entire wider financial plan in jeopardy.

You can create a financial plan that carefully balances the risk you take on

If the subject of risk is on your mind as you look to the future, working with a financial planner can be powerful.

When you work with us at Douglas White Financial Planning, we’ll build a financial plan specifically tailored to you and your goals for the future. We’ll help you calculate what you need to live your ideal lifestyle, and then design a strategy to get you there.

As part of this, we’ll create an investment strategy tailored to your risk profile using three key criteria:

• Need. How much investment risk do you need to take on to achieve your goals?
• Tolerance. How comfortable are you seeing your investments fall and rise in value?
• Capacity. What is your capacity for risk? How much could you afford to lose entirely without disrupting your wider plan?

In doing so, we can find the most appropriate investment solutions for you, helping you reach your targets without taking on an unsuitable level of risk.

Of course, this approach doesn’t mean your investments can’t fall in value. For example, in March 2020 when lockdowns were imposed around the world to stop the spread of Covid-19, markets fell significantly.

Consider this graph of the FTSE All-World Index, an index of around 4,000 medium to large companies around the world, from July 2019 to July 2024:

Source: Financial Times. Past performance is not a reliable indicator of future performance.

As you can see, when lockdowns were imposed in March 2020, this major stock market index dropped heavily. Even the most low-risk portfolio containing investments on this index would likely have fallen in value at this time, testing the risk tolerance of most investors.

Fortunately, this is where taking advice and having a financial plan can help you mitigate the impact of that risk.

For example, imagine that you’re retired and your pension is in drawdown. The markets fall in value, meaning you would have to liquidate more of your investments to draw the same level of retirement income.

A financial planning approach involves preparing for this eventuality, setting money aside in cash to tide you over in this event.

That way, you could turn off your drawdown for a year or two and live on your cash savings until the market has recovered – all without any impact on your lifestyle.

These are the types of risk management strategies you can employ when you have a comprehensive financial plan.

Get in touch

Would you like support in creating an investment portfolio that’s tailored to your personal tolerance, need, and capacity for risk? We can help.

Email info@douglaswhiteltd.com or call 0151 345 6828 to find out what we can do for you.

Please note

This article is for general information only and does not constitute advice. The information is aimed at retail clients only.

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.