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Risk: How much can you afford to take?

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AR011088 04/2018

When it comes to retirement income, you need to think about risk in two ways.

1. Your capacity for loss

Capacity for loss, in the context of retirement income, is your ability to sustain an investment loss but still be able to cover your fixed expenditure needs.

For example, let’s assume that someone can draw roughly £4,000 a year for life from a £100,000 savings pot. However, if their investments did badly and the value of their pot fell to £75,000, they would only be able to extract around £3,000 a year.

Could you weather a £1,000 fall in income without it making a big difference to your standard of living? For some people, the answer to this question will be yes, and for others, the answer will be no.

If a £1,000 reduction in income meant that you would not be able to meet your fixed expenditure then your capacity for loss is very low or even nil.

If you have a low capacity for loss, then you should aim to cover your fixed expenditure fully with income that is guaranteed for life. This is true even if you are personally comfortable with taking investment risk.  

If, however, a £1,000 reduction in income means you just have to cut back on some luxuries, then you have a higher capacity for loss. 

If you have a higher capacity for loss, then you are able to take more investment risk. But that doesn’t mean you have to take more investment risk if you are not comfortable doing so.    

2. Your attitude to risk

Attitude to risk is the other aspect of risk that you need to think carefully about.

This describes how comfortable you feel personally when taking investment risks.

There are a number of ways in which you can determine your attitude to investment risk. For example, you could complete a risk questionnaire which predicts what sort of investments you would be comfortable investing in.

You might also adopt different attitudes to risk in relation to different goals. For example, you might adopt a very low attitude to risk when it comes to covering fixed expenditure, but a higher attitude to risk when thinking about discretionary expenditure.

Investments are usually split into five grades ranging from low to high. The following table shows the types of investments that may be suitable for a person with risk tolerance in that category. Similar tables are widely available, but bear in mind these may differ from each other, so regard the following as a rough guide.

Risk level

Types of investment

Low

Low risk investments usually aim to provide returns similar to those you would get from deposit and savings accounts, although there may still be a risk that the value of your investment could fall.

Low to medium

Investments that are expected to provide better long-term returns than savings accounts. These funds typically invest in high-quality corporate bonds or provide a form of guarantee or capital protection, although there is still a risk the value of your investment could fall.

Medium

Investments that have the potential for better long-term returns than lower risk funds, although there’s a risk the value of your investment could fall. Generally, this involves investing in a diversified mix of assets including shares and commercial property and in lower quality corporate bonds issued by companies that have a higher risk of defaulting.

Medium to high

Shares (equity) of larger and well-established companies. For example, shares of companies listed on the UK main market or other major stock markets. Fund prices may fluctuate significantly but offer the potential for good returns over the long term.

High

Higher risk sectors. For example, emerging market shares or specific themes, such as new start-up companies. These investments offer the greatest potential for long-term returns, but the highest price fluctuations and risk of losing money.

 

Although you may be attracted by the higher potential returns of higher-risk investments, you may find it deeply uncomfortable if these investments then sustain large losses. People whose personal tolerance to risk is lower should choose investments where the risk of loss is lower, even if the potential for returns is also lower.

And, regardless of your personal attitude to risk, you should avoid higher risk investments if your capacity for loss is low.

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