Understand risk and you're on the way to managing it

THE basic principles of risk assessment should remain constant when considering investments – over what period will the investment run and what is the desired objective. If objectives are long term, such as retirement, it is important to consider what different asset classes offer while taking into account any volatility.

Within the differing asset classes, cash has been through a long period where interest rates have been modest and mostly predictable. Inflation and a measure of taxation have generally resulted in capital reducing in real terms – not exactly what is required for long-term objectives. Equity investments can be volatile, as experienced over the last several years. This is a constant dilemma for most investors who try to balance risk and reward.

One of the more effective methods of managing risk and securing equity exposure is through pound cost averaging. Pound cost averaging is achieved by investing a fixed amount of money in a particular investment vehicle (shares or fund) on a regular, usually monthly, basis.

When prices are high, contributions may buy fewer shares or fund units, but when prices are low contributions buy more shares or fund units. It is a strategy that benefits from volatile markets. The more the market swings the greater the potential benefit provided the investments are held until the market recovers.

The continuous drip-feed method of investing results in the average purchase price paid over any given period being lower than the arithmetical average of the market price. Investment decisions are less worrying. There is no need to panic when the price falls because you will merely be buying more of your chosen investment and, by spreading contributions over time, there is no worry about committing investments funds at the top of the market.

In a bear (falling) market, pound cost averaging allows you to build up an investment poised to benefit from a recovery without having to worry about trying to work out when the bottom of the market will occur. However, the strategy will mean you would lose out on the best of the growth in a bull (rising) market. For many investors, this is a small price to pay for the added security that pound cost averaging brings to investment decision-making.

There are a number of steps you can take to assess where you are in terms of reaching your long-term objectives and how much risk you are prepared to take to achieve those goals. There is a substantial difference between understanding risk and managing risk. The former should be your first objective in long- term financial planning. Only when you understand risk can you really take effective steps to manage it.