Attitude to Risk
As a paraplanner, I have spent a couple of years doing exams here at Jacksons, and prior to this, I worked for an investment platform. I like to think I have accumulated some good personal investing knowledge, but over time this knowledge becomes second nature and it’s easy to lose sight of what misconceptions our clients might have.
With this in mind, I wanted to create a series where I go over key topics of what these misconceptions sometimes are and try my best to demystify or simplify them.
I wanted to start with investment risk as it’s a key part of what we look at when handling a client’s financial plan. It’s also a topic which requires a larger discussion when getting to know a client and again at their future reviews, as it can and does change.
The Myth
The common perception is that the more risk you take with investing, the more likely you are to lose all of your hard-earned savings. This makes sense as I think people often see investing as gambling on companies which might or might not go bust, so it would follow that putting your life’s savings on 17 Red on the roulette table probably isn’t going to achieve your life goals.
The Reality
Risk and volatility are not the same thing, but often it’s the case that the more risk you take with investing, the more volatile the investment will be, but what is volatility? Well, put simply if you invest £1,000 today and week on-week it stays the same and doesn’t go up or down, this has no volatility.
In this situation, no volatility is bad as the money hasn’t kept up with inflation and your £1,000 pot loses its buying power. Essentially, this is what happens to cash held in the bank.
A more volatile investment will go up and down on a daily basis but historically, in any given year, 75% of the time markets go up and 25% of the time they go down, meaning overall investments tend to go up over the long term. So, depending on how your money is invested, the ups and downs will be more or less severe in effecting the overall return. Should you happen to look at your pot when it’s down, which will definitely happen multiple times in your investing timeframe, this will understandably be distressing, so this must be something you are comfortable with.
It’s part of the job of your adviser to guide you to the right risk profile for you, so that you keep your cool and don’t make a snap decision, sell your falling investment and actually realise the loss, locking that loss in and affecting your financial plan.
The graph above shows a comparison between a fund with 80% equities (in purple) and only 20% equities holdings (the lower line, in orange). Volatility tends to come from investing in equities i.e. company shares. This is because their values go up and down on a daily basis depending on many factors, and sometimes, very occasionally, yes, a company may go bust. Lower volatility typically comes from investing in bonds which are company or government debt. But there’s lots of generalisation going on here – all investments have outlier years, ask any bond investor in 2022.
Diversification
Most investment funds traditionally invest in hundreds or even thousands of equities and bonds across the world, the idea being that if one company, region or sector is hit by a market dip or we see sanctions on countries like we’ve seen recently on Russia, the relative stability of the other investments within that fund will balance this out.
Diversifying investments is an attempt to reduce volatility, that is, the fund price is likely to go up and down less dramatically. However, if you invest in just one or two companies, there is of course a chance they could go entirely bust. It might also be the case that you have invested in many companies which share a common sector or region and so if one falls, the others might be impacted.
For example if there is a shortage of a component used to make computers, and all your shares are in companies that make computers, they will all be affected as there is no offset.
Diversification is not just about numbers of companies you are invested in, they need to be different kinds of companies, in different sectors and in different parts of the world.
Organising this is challenging for ordinary investors, and this is why the preference here at Jacksons is to avoid stock picking and track the market.
Investment funds are either actively managed or passively invested. Active funds will typically have a team behind them who decide what to invest in depending on market timing, trends etc, as they try and beat an index like the FTSE 100. This team of people makes the fund more expensive.
A passive fund will typically track an index such as the Vanguard FTSE global index and is therefore cheaper as the investment decisions are made by company performance - essentially you are matching the global trend. The companies in this global index currently are Apple, Microsoft, Amazon and many thousands of others based around the world and in various sectors. For all of these companies all went bust, something larger than the pandemic and multiple concurrent conflicts would have to occur.
So how can risk be used for your plan?
Most of us are in one of two life stages: we are either accumulating or decumulating wealth.
When we are accumulating wealth and not needing to withdraw money for retirement, volatility is our friend, and generally we are invested for the long term and for overall investment growth.
Entering into retirement, volatility typically is not your friend because you ideally want to avoid having to dip into capital when it is distressed, that is, down in value. That’s why we suggest that in retirement you will want to keep the next two years’ spending needs in cash, and top this up from future profits. A very volatile investment in retirement makes this a more challenging prospect.
Summary
I hope that this article has been helpful and given you some clarity on investment risk or maybe addressed any notion you might have held and either supported it or challenged it. Please remember, diversification is key for any portfolio, whatever life stage you are in.