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What is Financial Risk?


In Financial Planning Module 1 I discussed what Financial Planning is. In the next modules I will discuss different aspects of Financial Planning to understand how a Financial Plan may be established to achieve personal goals. In this module I am looking at monetary risk.

‘Risk’ is a word synonymous with money but financial risk can take many forms; the major types are listed below:

Investment risk  
The chance the value of your capital will fall. The greater potential return you wish to have the greater the chance of capital losses.

Inflation risk
The purchasing power of your capital decreases over time if the interest rate you are receiving is less than the increase in the cost of goods and services. This is why it is often not sensible to have all of your capital in cash (or under the mattress!).

Institutional risk
If all your capital is within one institution there is the risk that it will all be lost if that institution becomes insolvent. Think HBOS, Royal Bank of Scotland & Northern Rock.

It is prudent to spread capital amongst a number of institutions and keep within the Financial Services Compensation Scheme limits.

Political Risk
A change of government often brings a change to taxes and personal allowances which can cause a Financial Planning strategy to become inefficient.

In extreme cases governments default on their debt payments due to unmanageable budget deficits leading to economic turmoil. This has never happened to Britain, yet!
 
Advice risk
If you seek financial advice there is the risk that the advice you receive is inappropriate and will leave you worse off. Whenever you seek advice shop around, understand what qualifications your chosen adviser has (experience is not a substitute!) and understand their motive for the advice they give (how are they getting paid?!).

As an investor it is important to decide to what extent you are exposed to each one of these financial risks. The level of exposure will depend upon a number of factors including:

1.  Your age: Typically, the older you are the less you may wish expose capital to financial risk.

2.  Your investment time frame: The longer you have to invest the longer you have to accept the chance of short term capital losses in pursuit of greater returns over the long term.

3.  Your investment goals (your SMART objectives): If capital preservation is more important than growth less risk exposure is required, and vice versa.

4.  Your tolerance to investment risk: Everyone has a psychological feeling towards risk, often measured on a scale of one to ten. The lower your tolerance less financial risk should be taken.

So, before embarking on a Financial Plan you need to understand which financial risks are acceptable to you and to what extent you should be exposed to them.

Article by Andrew Neligan. He is an award winning Chartered & Certified Financial Planner at Informed Choice Ltd who specialises in providing Financial Planning services to Legal Professionals.  More information can be found at icl-legal.co.uk.



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