Understanding investment risk, return and taxation – Episode 3 – Grow It

5 min Read Published: 09 Mar 2023

In this video series I provide an introduction into investing. By this point in the series, you will now understand why you should think about investing and also the things to think about before you start. In this video, I'll cover understanding investment risk and return as well as the relationship between them. I will also touch upon how your investments may be taxed.

Understanding investment risk, return and taxation

(In the video we mention the annual tax-free allowance of £12,300 at the time of making this video but this will drop to £6,000 in April 2023 and then £3,000 from April 2024)

Investing your money can be a great way to grow your wealth over time, but it comes with risks. Investment risk refers to the possibility that your investment doesn’t perform as you’d expect. This includes the likelihood that you lose some or all of your money. When we talk about investment return this is the difference between what you get back and the amount of money you originally invested.

First of all let’s explore investment risk. There are different types of investment risk which include market risk, credit risk, liquidity risk, currency risk, inflation risk and interest rate risk. Different assets that you invest in will be exposed to these types of risk to varying degrees.

The greater the level of investment risk the greater the potential return that you can achieve but there is also a greater chance that things may go wrong and you lose money. The relationship between risk and return is an important one but because investment returns are not guaranteed and it is difficult to quantify.

While past performance is not a guide to future returns, studying the risks and returns of different assets over time can provide insight. The Barclays Equity Gilt study is an annual report that analyses long-term investment returns in the UK. It looks at the performance of UK equities and gilts (which are government bonds) and cash over different time periods, going back to 1899. According to the 2021 study, equities have historically offered higher returns than gilts, but they also come with higher risk.

Equities have achieved an average annual return of 5.5% above inflation, while gilts have an average annual return of 1.3% above inflation. However, equities are also more volatile than bonds, meaning that their returns can vary more widely from year to year. In fact, equities have experienced negative returns in 22% of the years analysed in the study, compared to only 6% for gilts. One key takeaway is that the stock market has seen large swings in returns over short periods, but long-term returns have been positive.

So, what does this mean for investors? It means that if you're willing to take on more risk, you may be able to achieve higher returns over the long term. However, you also need to be prepared for the possibility of losing money in the short term. If you're more risk-averse, you may want to consider investing in lower-risk assets such as bonds, even though they typically offer lower returns. But it doesn't have to be an either or choice. By investing in a range of assets, should any underperform for a period of time then the performance from other parts of your investment portfolio should hopefully mitigate these losses and help smooth out the returns over time. This is known as diversification.

It is important to assess your own attitude to risk before you start investing. That way you can make sure that you are making the right investment choices for you.

So before you go any further it's important to understand your risk profile. One way is to ask yourself how you would feel if your investments lost value. Would you be able to handle the loss without panicking? Or would it keep you up at night? What do you need the money for when? Can you afford to lose all of your money? A more technical way to assess your attitude to risk is to complete a risk assessment questionnaire, which will ask you questions about your financial situation, investment goals, and risk tolerance to help you determine an appropriate investment strategy. There are risk profiling questionnaires online which you can use for a one-off fee and I link to one such service in the notes of this video. It is very similar to the type of questionnaire many financial advisers use to assess your attitude to risk before they make an investment recommendation. Another alternative is to go through the risk profiling journey offered by many so called robo-advice or online investment services. While you may have to register your details, there is usually no obligation to invest but you can still make use of their risk profiling journey. Again I have shared a link to our best buy table of these propositions which you can then look through.

Now I want to briefly move onto taxation. Any profits or income produced by your investments will be liable to taxation. In the notes of this video I’ve put a link to a full explanation of how investments are taxed, but broadly if you receive income from your investments, such as dividends from shares or rental income from a property, you may have to pay income tax on that income. The rate of income tax you pay will depend on your total income, including your salary and any other sources of income. The current rates are 20%, 40% and 45% that are applied depend on how much you earn. However there is an annual personal income tax allowance which is currently £12,570. You'll only pay income tax on any earnings which are above this threshold.

When you sell an investment that has increased in value, such as shares or a rental property, you may be liable to pay capital gains tax (CGT) on the profits. The CGT rate is 10% for basic rate taxpayers and 20% for higher and additional rate taxpayers. The rates are different for gains made on property. However, there is an annual tax-free allowance of £12,300 at the time of making this video but this will drop to £6,000 in April 2023 and then £3,000 from April 2024. As long as your gains do not exceed this amount in a tax year, you won't have to pay any CGT. Importantly I am not referring to gains on paper, but actual gains made when you’ve sold the investment.

The great thing about investing is that it is possible to mitigate most tax that could be applied to your income and gains by investing via products such as an ISA or a pension. Not only can you legitimately avoid paying on what comes out of your investments but your money can grow tax-free while you are invested and in the case of a pension you can even receive tax-relief (essentially tax back) when you pay into it. I will discuss ISAs and pensions later in this series.

If you understand investment risk and return as well as your own risk profile you can make investment decisions that are suitable for you. By being mindful of how investments are taxed you can not only make sure that you keep most or if not all of your income and profits from being taxed but you can even get a boost from HMRC too.

In the next video I will look at when you need a financial adviser and when you don't.

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