Estimating Investment Risk
People are generally very bad at estimating risk and deciding whether they should be concerned or not when given a statistic. As illustrations, please think about the chances of winning the National Lottery Lotto draw and chances of being struck by lightning.
In the weekly Lotto draw, your chances of winning the jackpot are 1 in 45 Million; to win a Million, the odds are 1 in 10 Million, as there is the raffle draw as well. Your chances of winning any prize at all are 1 in 9.3, so there is often a small win to keep you interested.
As a crude measure in any year, you have about a 1 in a million chance of being struck by lightning, given that in any year between 30 and 60 people a year get hit in a population of about 60 million.
To put this in perspective, do you worry about dying in a car accident? Most people probably do not concern themselves about car accidents, but they are much more common. In 2013, 1,713 died in traffic accidents, giving odds of getting killed on the roads in any given year of about 1 in 35,026. Mathematically, you are about 29 times more likely to be killed on the road than be struck by lightning, but I suspect that you will consciously take more care when thunderstorms are forecast, than driving down to the supermarket.
Risk with investments are much harder to quantify; there are more variables and potentially many more outcomes. Normally though, investors are only really concerned when their investments do down in value below the level of the original investment or the original investment plus bank interest over the same period.
Talk to almost any adviser and they will have some methodology to estimate your Attitude to Investment Risk. For us this is a questionnaire that asks a small number of similar questions, like a personality test, where the responses are evaluated and a risk rating given.
In order to quantify the level of investment risk anticipated, you need to read the documentation provided by the designers of the questionnaire, as there are a number of different proprietary schemes around, using different scales and different definitions, but as a generalisation, the lower the number the lessor the risk.
Using the FE risk index, 0 is no market risk, 1 = Cautious, 3 = Balanced, up to 5= Adventurous. FE Index 1 is calculated to be 30% of the investment risk of the FTSE 100 index. The FE Risk Index is used to classify the funds on the www.trustnet.com website.
Everything in life is a risk, so taking no risk is an impossibility, but conversely taking too much, either deliberately or accidentally is unlikely to be good for your health or your wallet!