The four letter word in investment planning
Understanding risk, and what is meant by risk, is essential in determining an appropriate investment strategy and in managing your own expectations when it comes to investing.
The concept of risk is difficult to define as it encompasses a broad range of notions and can mean different things to different people depending on individual experience and circumstance.
The only thing we can say with absolute certainty when it comes to risk, is that we would all prefer less of it while not having to sacrifice any long-term return potential.
It may be helpful to consider risk in three ways:
(i) Your tolerance for risk – this represents the emotional extent to which you experience a change in the value of your investments. It is essentially the level of risk you would prefer to take or your willingness to accept risk.
(ii) Your capacity for risk – This refers to the ability to take on a specified level of market risk. It is the capacity to soak up short-term price movements that deviate from expectations without causing a significant reassessment of your long term financial plan.
(iii) The risk you are required to take – This represents the amount of risk you will have to take in order to meet your objectives. Even though you may have a low tolerance for risk, you will probably not meet your objectives by investing in cash and bonds delivering 6.4% a year on average.
Your investment strategy should encompass a balance between all three of these concepts but it should, in the first instance, ensure that you can generate the required investment returns to meet your objectives rather than to meet your tolerance for risk.
Types of risk to be aware of:
(i) Volatility – This is the most common expression of risk and is typically measured by a standard deviation. It is essentially a measure of market risk or the risk of an asset falling in value. In short, if an asset class or market has delivered an average return of 10% over the last 10 years and has a volatility or standard deviation of 5% over that period, then the range of expected returns from the asset class should fall between 5% and 15% a little over two-thirds of the time. It is important to note that this represents an average expected return and range but over shorter time periods you can experience much greater gains and losses to reach this average.
(ii) Shortfall risk – the risk of an asset not growing quickly enough to meet your objectives. It is the risk that you do not gain enough exposure to assets that will deliver a high enough return to achieve your financial goals. If you are investing for retirement in 20 years time, and you require a return of 12% a year based on your initial capital plus additional contributions, then you run the risk of not achieving this objective if you invest solely in cash and bonds which historically only provide an average return of 6.4% a year.
(iii) Inflation risk – All financial plans imply a rate of inflation when assessing what your income requirements will be by the time you retire. In most cases this inflation rate will be based on a broad basket of goods such as the Consumer Price Index and is usually a reflection of historic levels of inflation.
Of course forecasting inflation 20 years or more in advance is not a particularly accurate past time but you should be aware that if you use a 6% inflation rate to project your annual cost of living when you retire in 20 years time and the realised inflation rate is actually 9%, then you are likely to experience a significant shortfall in retirement savings relative to your original plan.
By monitoring inflation and having a focus on REAL RETURNS (after inflation) from your investments you can mitigate this risk to a large extent over the long term.
Factors that impact on risk appetite:
(i) Time horizon – Essentially the longer your investment time horizon the better placed you are to sustain any short term fluctuations in market prices. Even some of history’s greatest market “crashes” can appear a mere blip on a long-term chart.
Basically, you can invest in the supposedly riskier assets such as equities and ignore the short-term market moves while you capture the long term benefits of greater average or expected returns. (Of course this is all very simple in theory but it takes discipline and patience to implement in practise when you actually experience significant paper losses).
If you are only investing for a period of three years then you cannot afford to suffer years where you can lose up to 30% of your capital as you will possibly not be able to ride out the inevitable recovery.
(ii) Size of existing investment pot – If your existing investment ‘pot’ or portfolio is already large (let’s say 50% of what your 10 year goal is) then you can afford to take on much less risk as you will require a lower average annual return to achieve your goal.
Of course in this case your capacity to take on more risk is also greater, if that’s the way you want to go, because you can suffer some of the more severe short-term fluctuations without ruining your chances of successfully reaching your objective.
(iii) Emotions – One of the biggest single hurdles investors face is overcoming their emotions when it comes to investing. Emotion driven investing can have disastrous consequences – typically investors have a greater appetite for risk when things are going well. If equity markets have gained 30% in a year, most investors feel more comfortable adding risk and tend to buy at higher and higher price levels.
Conversely when markets go on sale and fall by 30% investors tend to stand back from the market or even consider selling some positions.
By having a better understanding of your own concept of risk, and by being aware of the potential types of risk you can be exposed to, you should be better equipped to combine your willingness and capacity for risk into a successful strategy that meets your required returns.
Please contact White Investments if you have any queries regarding the content of this article or require further assistance in compiling an investment plan that suits your risk and return objectives.