This article was first published on 5th October 2018
What is risk?
When investment professionals and financial advisers talk about investment risk they use words like ‘downside’ risk, ‘volatility’ and ‘probability’. We nod sagely, submit to a ‘risk assessment’ and take their advice on a high, mid or low risk investment portfolio.
When we talk about risk, it is typically in the context of not achieving a desired outcome.
Here are a few examples:
“the car is making a strange sound, there is a risk we won’t get to the in-laws for lunch”
“we keep buying the lottery ticket but the risk is that we never win the prize”
“if you don’t work hard there is a real risk that you won’t get into university”
Should investment risk also be defined in the context of the desired outcome? Not only is the answer ‘yes’ but by doing so we could become much more successful investors.
In the real world, we invest for many different reasons. At age 30, we invest our pension savings to maximise the pension pot at age 55 (when we can draw on it) or later; at age 65, we may need to draw some cash every month while continuing to invest the balance. Other savings may be for a specific purpose – house, car, holiday – in which case we will target an amount by a particular date or year; or we may simply want a rainy day fund which might be called upon at any time in the next 10 years. Banks and some Trusts may be required to maintain Financial Reserves and will fail a supervisory test if the reserve falls below the minimum amount required.
When investing in each of the above cases, the critical issues are to understand your objective and what would happen if you didn’t meet that objective i.e. the risk of failure.
In each of the above, the risk of not meeting your objectives is what really matters. The young pension saver has a lower retirement income; the older pension saver runs out of money; the rainy day saver cannot paint the house or go on holiday; bank activities are curtailed or the Trust is closed down for not having sufficient financial reserves.
Different objectives requires each investor to adopt a different investment strategy.
Young pension saver
Objective: maximise savings and investment return over 25 years.
Strategy: Ignore short term market volatility. Invest in a globally diversified portfolio of company shares to maximise return. Revisit the strategy at least 10 years prior to retirement.
Older pension saver
Objective: make cash available for retirement income while preserving the value (in real terms) of the remaining portfolio.
Strategy: Keep a cash buffer of at least two years income while investing the remaining portfolio in a globally diversified portfolio of shares and bonds.
Rainy day saver
Objective: Have cash available when payment needs to be made for the house, car, holiday or repair.
Strategy: invest cautiously with the majority of funds retained in cash and savings accounts. As soon as the ‘target’ amount is reached sell ALL non-cash investments.
Objective: maintain the minimum value of reserves required by the supervisory body.
Strategy: invest the required reserves in cash or UK Government Bonds and only invest any surplus funds in non-cash assets.
In the real world of Booming Lives members, investment risk would be better measured in the context of failure to meet your objective i.e relative to an outcome and NOT the usual measures of ‘downside’, volatility and probability. Traditional measures focus the attention on market fluctuations during the investment period whereas the real issue is potential loss at the time of needing the money. ‘Downside’ risk measures have a little more value but in practice confuse two different objectives; safeguarding a minimum amount and making an investment return on the surplus if any remains at the end of the investment period.
There is a class of funds known as Absolute Return Funds (ARF) which typically set a return objective relative to Cash. That does not mean they cannot give negative returns. Many have in the last couple of years as I know from experience! My Income Drawdown account has a cash buffer of more than two years of income and I now realise that investing in ARF funds is at odds with my other objective of preserving the real value of the remaining portfolio. Time to sell.