Understanding investment risk
In an investment context, risk has two components. The first is linked to the performance of a specific investment and can involve a total and permanent loss. Shareholders in Carillion have lost all of their money and no matter how long they wait, it will not recover its value.
Specific risks should usually be minimised unless you are confident that you know more than others about the investment. The best way to minimise specific risk is to diversify by investing widely. In a typical EQ Balanced Risk portfolio the largest single equity holding usually represents less than 1% of the whole portfolio.
The second type of risk is linked to market fluctuations. Investments rise and fall in value depending on sentiment, often linked to prevailing views on the future course of company profits, inflation and interest rates. These fluctuations can be violent – in 1973/4 the UK stock market fell by more than 70% and in 2008/9 by almost 50%. However, if you wait long enough, market declines have almost always been reversed (Japan has been an exception, still well below its 1989 peak). So market risk is really only a problem if you have to sell during a downturn or if you panic when the news turns bad.
As human beings we are poorly equipped emotionally for dealing with adversity and accepting mistakes. This is entirely normal, but not very helpful for maximising investment returns – it can lead people to sell after markets fall and then refuse to buy back when they bounce.
One of our risk profile assessment goals is to understand your appetite for risk. This is partly to do with your personality. We both need to feel confident that you won’t lose your nerve when markets take a downturn – which they inevitably will from time to time. We want you to realise gains, not losses!
The other dimension in allocating your portfolio has nothing to do with psychology. It’s all about providing you with financial security in the long term. Your capacity for loss is taken into account, based on a series of calculations that looks at your income, expenditure, projected savings and future needs.
Part of our process is to show you what might happen in a severe market downturn. For example, the peak to trough decline in an adventurous portfolio during 2008/9 would have been in the region of 25%. That would have been uncomfortable at the time – but not a surprise if you knew that was likely to happen occasionally. It recovered from the loss within a year, so that old adage: “it’s time in the market that counts, not market timing” really is spot on.
Many people should be thinking in terms of decades for their investing timescale, especially if they are still accumulating. In that case it may make sense to have a relatively adventurous portfolio, with a view to reducing risk later in life when you start to withdraw capital. Even then, if you start to draw down an income at age 65, you could be invested for more than 30 years. So while it may be a good idea to reduce your risk, it doesn’t make sense to take it all off the table.
Adventurous portfolios aren’t guaranteed to earn higher returns than cautious ones. But they do have the potential to return more – and for many people that potential is worth having, even though the ride will be bumpier.
Andrew Rees, Investment Manager