Risk level is key part of the plan

By Bina Brown
For CNN

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(CNN) -- Risk means different things to different people. If you asked a group of people which is more risky: jumping out of a plane with a parachute or without a parachute, overwhelmingly, the answer would be without a parachute.

However, there is no uncertainty if you jump without a parachute; you know exactly what's going to happen.

In contrast, while you'll probably survive with a parachute, it's not a certainty.

And just as we would all like financial markets to keep going up, there is no certainty that is going to happen. Most asset classes -- be it shares, property or fixed interest - are at risk of going down at some point.

Some people are comfortable with that concept and can cope with a portion of their investments going down -- as long as they also go up over time. Others won't be able to sleep well at night just knowing there is a chance they could lose money.

It is important to be comfortable with the level of risk you are taking. But it is also important you are invested in a way that helps you reach your financial and lifestyle goals.

It might bring great comfort to have all your money in the bank but it probably won't earn you the income you need to live off.

Generally, financial advisers work with clients to help develop a risk profile which will then determine how their money is invested.

An important part of an adviser's role is to make sure there is a balance between a client's risk profile and portfolio volatility. But equally important is putting together a portfolio which gives thought to the level of risk a client is comfortable with but that can realistically meet the client's financial goals.

Essentially there are two categories of risk: market and non-market. Market risks such as interest rates rises, tax changes and a slowdown in economic growth have an impact on all investments in a similar manner. It is a risk that cannot be avoided.

Non-market risk on the other hand is linked to individual investments and can be avoided through diversification. By spreading your investments across the different asset classes of cash, international and domestic shares, fixed interest and property, you can protect yourself from a downturn in one area.

Australia-based managed funds researcher van Eyk believes that determining your risk profile will be the single largest decision you make as an investment.

Effectively, when a person decides on a risk profile he or she is deciding on a default strategy, or asset allocation. Research studies have shown that a person's default strategy will drive 80 percent of the investment returns.

The most important part of asset allocation is the split between assets that provide growth, such as shares and listed property trusts (which are more variable in their performance), and defensive assets, such as bonds and cash management (which are less variable in their performance).

Within those asset classes you should be prepared for a range of returns in any one year, which should smooth over the long term. For shares it can vary between a gain of 40 percent in one year to minus 30 percent, but over the longer term a 10 percent return would not be unreasonable.

Cash is at the other end of the return scale. While a negative return in any one year is unlikely, 10 percent in one year would be exceptional and the expected long term return more like 5 percent.

"There is a definite trade-off between the security of cash management and the long term growth opportunity of shares," says van Eyk director Mark Thomas.

"If you are an investor of 10 years then the riskiest thing you can do is put all your money in cash as inflation will erode it," he says.

Next: Know your tolerance to risk

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