Investing can be scary and obviously not without risk, but it’s important to understand what these risks are. As well as how to exploit some key investing principles, explains Jason Butler.
The two main risks that most investors face are:
1. Living too long for the wealth they have (known as longevity risk)
2. Inflation eroding the purchasing power of the wealth (known as inflation risk)
Consequently, most people need their personal wealth to generate annual returns which are higher than inflation.
In investment terms risk and return are related, in that the more return you want the more risk you have to accept. In effect, accepting the potential for loss of capital and daily fluctuations in the value of your capital is the price you have to pay for avoiding longevity and inflation risks.
“The cost of getting this wrong is likely to be far higher than the fees your adviser will charge for their knowledge and experience to help you to get this right”
All the available academic evidence supports the following key investment principles:
- Capitalism works well enough
- Stockmarkets are an effective enough pricing mechanism
- Diversification (not putting all your eggs in one basket) is the only ‘free lunch’
- Asset allocation determines the majority of the variability in a portfolio’s returns
- Costs matter and are something tangible which investors can control
There are also three dimensions (or factors) that govern investment returns, which are possible to exploit without involving individual investment manager skill or luck. Think of these as a bit like morality without religion, an approach that is based on the facts not faith:
- Equities (owning a share of world class profitable companies) have a higher expected long-term return than bonds (loaning capital to companies and governments)
- Companies which have a low share price relative to their assets (known as ‘relative price’ or ‘value’ shares) or are small have higher expected returns over the long term, compared to the stockmarket as a whole. This is believed to be because they are more risky and therefore have to pay more for their capital
- Profitable companies which have a statistically higher probability of maintaining those profits (known as expected profitability) tend to have higher returns than the stockmarket as a whole
Risk factor exposures*
Your investment strategy needs to be based on your risk profile, which comprises three elements of risk:
- The investment risk you need to take to achieve your goals, i.e. the annual rate of real return that you need to maintain your lifestyle and other goals
- Your emotional tolerance to risk, as measured by a psychometric risk testing tool
- Your financial capacity to adapt your lifestyle in the event of a permanent loss of capital and/or investment returns turning out to be lower than anticipated. This involves carrying out a number of ‘what if’ analysis to see the impact of different scenarios.
Qualified and regulated financial advisers can help you to ascertain the annual rate of investment return that you need to meet your goals and whether this is realistic, given your emotional tolerance and financial capacity for risk. If the required real rate of return is too high then your future goals or other planning assumptions about current spending, earning, saving and how long you work may need to be changed.
The key to a successful investment experience is to have the context and clarity of a well-structured financial plan which takes into account why you are investing, how best to achieve your life goals and the risks that are most likely to be compensated in the form of long term investment returns. The cost of getting this wrong is likely to be far higher than the fees your adviser will charge for their knowledge and experience to help you to get this right.
Find a financial adviser in your area to help your investment experience run smoothly.