How much risk are you prepared to take with your money?

Most investors become more cautious as they get older. This makes sense; if you are young and have time on your side, then you can afford to be a bit reckless, in the knowledge that you should have room to recoup your losses. The older one becomes, the more catastrophic are the consequences of making a substantial error of judgement with one's savings. Getting the balance right at different stages of life is very challenging though, and not something that we are instinctively good at - in fact people are not always good at judging risk.

Here are a couple of examples to show what I mean, and then a couple of useful (hopefully) suggestions.

Many people are frightened of flying, and as anyone who has experienced a bumpy landing will testify, this is entirely understandable. Nevertheless, you are more likely to get killed driving to the airport, than you are taking your flight. In fact, analysis of US Traffic Department data suggests that following the 11 September 2001 attack on America, after which many millions of Americans chose to drive rather than fly, the number of additional road deaths in the three months following the attack actually exceeded the number of people killed on the four fatal flights.

There is some evidence that we are hard-wired to be conservative when it comes to risk. The story goes that back when our principal preoccupation was finding enough to eat and staying alive, the risk weighting was on the down-side. After all, once you have been fed, the marginal return on extra food diminishes fairly rapidly, whereas the consequences of not having enough to eat, even for a short period of time, could be fatal.

Taking an example a little closer to the investment world, equities - company shares - are more volatile than Gilts issued by the government (i.e. bonds issued when the government borrows money), and much more volatile than cash. So the risk-averse investor might reasonably conclude that investing in shares is not for them. The problem is that over the short term, this philosophy is true, but over the longer term the reverse is the case. Research going back over 100 years to the beginning of the 20th Century, shows that longer-term investors are generally better off invested in equities. Over a ten year term, the probability of equities outperforming bonds is 82% and for cash it is 93%. Move the investment term up to 18 years, and the probability that equities will outperform bonds is 91%, and for cash it has risen to 99% (in other words, over an 18 year period there is just a 1 in 100 chance that you'll be better off in cash than you would be by investing in the stock market). Cash becomes the riskier investment.

For someone looking to invest their savings to generate an income - perhaps through a pension - the dilemma is how to balance off the various risks that they face. For example, if they live too long, then they could outlive their savings; to which the answer might be to buy an annuity, because it guarantees an income for life. Alternatively, they could find inflation eating away at their income; to which the answer might be to invest in equities, as hopefully this will provide a rising income over time. They might face the liquidity risk of not being able to get at their money when they need it in a hurry; to which the answer might be to hold some of their savings in cash (but not too much!). Any investment solution needs to be a compromise, to balance off these conflicting risks.

Given the improvements to life expectancy that we have seen over the past century, and the past thirty years in particular, this presents some interesting challenges for anyone in their fifties or sixties. I think that ultimately most people will still end up buying an annuity in their seventies (given current government rules, it is still quite hard to avoid it). Up until then though, I think investors can, and probably should make continued use of equity investments to maximise their overall return. Even after retirement, when an investor is drawing an income from their pension fund, our default investment mix (though not by any means the only one we use) is around 60% in equities and 40% in a mixture of bonds and cash.

There is also the option to mix and match investment arrangements. For example a £200,000 pension fund could be split, with half being invested in an annuity for maximum yield now and the longevity risk offset, and the other half being invested in equities via a drawdown plan to provide a lower initial yield but with long term growth.

There are some good answers to financial risk management out there, provided you are willing to go looking for them.

Hargreaves Lansdown is one of the UK's leading independent financial service providers and asset management specialists. Their experts can simplify and streamline your affairs and free up your time by helping you to choose, buy, sell, hold and manage your investments. For more information visit Hargreaves Lansdown or call their helpdesk on 0117 900 9000.