The hardest lesson for a new investor to learn is the fine balance between risk and reward. Jason Butler, of Bloomsbury Wealth Management, offers a lesson in how to understand and accept investment risk.
Risk means different things to different people. In the context of personal finance, most people confuse investment volatility (the ups and downs of equity and fixed income markets) with a permanent loss of capital. Professional financial planners and advisers, by contrast, see risk in terms of whether or not their client will achieve certain life goals (those with a financial implication).
An overarching goal for most people is to have enough income and financial resources to fund their lifestyle, most of all when they stop working (either by necessity or choice). Along the way they may well have other goals such as home ownership, funding their children’s education and possibly supporting causes that are important to them. Running out of money when they stop working, however, is the biggest concern for a large number of people, particularly given that life expectancy is increasing.
Few people ever quantify the financial cost of their life goals (such as having children) and as such don’t have much sense of how much they need to save and (more importantly) what returns they will need from their capital. This is where a lifelong cashflow analysis, as part of a structured financial plan, can help. (Click here to watch a very short video in which my colleague, Carolyn Gowen, explains the importance of having a plan.)
How to take risks – and use them
However, because the future will almost always turn out to be different from any long-term financial projection, this merely gives some context for making investment decisions. Most people can’t save enough to fund their life goals by investing in cash and/or fixed income investments, so they’ll need to include an allocation to commercial property and equities (shares in companies).
If you invest capital into a highly diversified investment portfolio (i.e. across thousands of global companies and dozens of countries), the chances of experiencing a permanent loss of all your invested capital over 20 years or more are extremely remote. However, stock markets do experience extreme swings in valuation from day to day, month to month and year to year. The most significant fall in the UK stock market in living memory was in 1973-75, when the market fell over 50%. To put this in context, in the 2008-2009 credit crunch it fell about 30%. However, sharp falls are often followed by even sharper recoveries, as demonstrated by the chart below for the 2008-09 period.
It is your ability to ride out these sharp but (so far) temporary investment market falls which determines whether or not you will have a successful investment experience. The evidence supports the fact that an investor’s emotional willingness to take investment risk, in the form of short-term volatility, is essential to achieving the long term investment returns that they need in order to meet their financial goals. Selling investments in a downturn, for no good reason, converts a temporary fall into a permanent capital loss. The evidence from many academic studies also reveals that investors, both amateur and professional, find it extremely hard to identify consistently when to buy and sell to take advantage of such dips – however confident they may be in their abilities to do so.
To help you stay the course, it is essential that your need to take investment risk (i.e. your need to get a certain level of return) is balanced against your emotional willingness to accept the inevitable falls that are part and parcel of investing. Professional planners and advisers go so far as to use psychometric assessment tools to help their clients understand the investment risk that they are willing to take (their ‘risk tolerance’). This tolerance can then be compared against the risk that their financial goals suggest they need to take (and also their practical ability to take such risks – this is called their ‘risk capacity’). In some cases, it may be necessary to pursue more modest financial goals, so that the investor can select a portfolio that matches their risk tolerance and capacity.
Risk need versus risk tolerance
The recent falls in world stock markets should serve as a reminder that market volatility is the price you have to pay for the higher expected return from equities, as compared to less risky alternatives. The future is always uncertain; otherwise there would be no additional return from taking investment risk. Historically, investors who have taken that risk via a diversified portfolio have been well compensated for doing so. A professional financial adviser will help you to work out your risk profile in terms of the principal elements of tolerance, need and capacity, while helping you understand the relationship between these three elements. Knowing whether you can cope with the investment risk necessary to pursue and achieve your lifetime goals is essential to having a successful investment experience.
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