Risk and reward are inextricably linked. In many scenarios, the more ‘risk’ you take the more return you get (within reason).
Broadly speaking this is true, but what do we mean by ‘risk’? Like most things in personal finance, it is exactly that, personal. Risk means something different to everyone. This blog aims to uncover the main three main risks to be aware of when investing over the long-term.
When it comes to investing, lots of people consider ‘risk’ as complete loss of capital. By this I mean, you invest an amount of money and you get nothing back.
A situation where total capital loss tends to be a major risk is when you have invested in a single company or stock. If that company or group goes bust, your investment is toast! Put simply, you have lost your entire investment. Recent examples include Carillion, British Steel, and Thomas Cook.
The same is true of FAD investments. Think about the recent hysteria around Bitcoin. A classic investment bubble that saw hysteria due to the initial growth and almost a complete collapse.
The usual suspects
When you work for a large listed company you can often participate in share schemes that allow you to buy their stock at a lower than market price. This is great on one hand, but you can end up becoming the proud owner of a single share portfolio and most at risk of complete capital loss if that firm went bust.
Aside from the inherent risk associated with the singular nature of the investment, as an employee buying shares, you will naturally be biased towards your own firm. This is a cognitive bias known as The Ikea Effect. The concept of placing a higher than realistic value on something you have built (or have been part of building) yourself.
This bias is compounded if the company has been financially strong in the past, potentially leading to Overconfidence Bias and the feeling you ‘can’t lose’.
Overall a recipe for (potential) disaster.
How to mitigate Capital Loss Risk
Diversification is often considered the only free lunch in investing. The ability to spread your risk among multiple holdings without dampening your long-term returns. The same is true of asset classes, sectors, and geographies. It is key to ensure your portfolio is spread across multiple holdings if you want to minimize the capital loss element of risk.
This also helps with the next risk on the list: Volatility.
In investing terms, volatility is the rate and degree by which an investments capital values fluctuate over time. Like Capital Loss, it’s one of things that concern novice investors the most, particularly when heading into retirement.
Of the three most popular assets in an investment’s portfolio (equities, bonds, and property), equities are the most volatile. Equity is another word for a share in a company, sometimes called a stock. You will own a small percentage of the company and you will participate in the rising capital value and income of said company.
The value of the equity is determined by the millions of daily trades from individuals and institutions. In short, in a totally fair market, it’s the participants trading in that market that ultimately determine the share price of that company.
The current situation with Covid-19 has provided the market with some extreme short-term volatility due to mass uncertainty and panic about the future of the companies in question and the larger economy. This has led to a fire sale and the assumed value of these companies to plummet in the short term. If you own shares in these companies, you will have seen the “paper value” of your portfolio drop.
The communications we have sent to clients over the past few months have mainly surrounding the volatility we have been experiencing due to Covid-19. The difference between Volatility and Capital Loss, however, is that the former is temporary and the latter is often permanent.
How do we mitigate Volatility?
Asset allocation is the process of splitting your portfolio holdings between different asset classes such as equities, bonds, property, etc. The role of these asset classes is different and the two main holdings in our portfolios: equities and bonds are inversely related, meaning that they move in opposite directions.
Equities (shares in companies) are used to provide you with growth. Bonds (loans to governments and companies) are used to minimize the volatility in the portfolio. They don’t grow as well as equities but provide low and steady returns which help during a period of equity market decline.
Blending the two is often the right answer. Although a 100% equity portfolio will likely provide the greatest long-term growth, the short-term volatility will be too much to handle for most investors.
This means we need to bake some bonds into the investment cake to ensure that you don’t become your own worst enemy and cash in your chips when the market is down. This is how uninformed investors turn temporary volatility into permanent capital loss!
We need to balance this desire for safety with our final risk factor – inflation.
Inflation is the percentage increase in the cost of everyday goods and services. Sometimes it referred to as RPI (Retail Prices Index) or CPI (Consumer Prices Index). It is the hidden, silent killer of the long-term investor’s portfolio and often ignored as a major risk factor.
For example, if you have a portfolio of £500,000 and you need to draw an income of £1,500/month in retirement, you have a withdrawal rate of 3.6% per annum. You would expect that even a portfolio with just 40% equities (growth assets) would be able to provide you with this return. In most cases, if constructed well, you would be right.
However, what you need to consider are two major factors;
Let us assume you are using an adviser and a well-diversified low-cost portfolio, managed on an electronic online platform (if you are working with us, then this is almost certainly the case). Your fees will likely be in the region of 1.5% including the advice, platform, and fund related costs.
Therefore, you now need a gross return of 5.1% per annum as a return (3.6 +1.5). Still a reasonable assumption based on the lower equity portfolio mentioned above.
However, what happens when we need to factor in 3% per annum for inflation too. That jumps to 8.1% per annum required in order to preserve the original capital. Suddenly only 40% in growth assets isn’t going to do the job. Now you will likely need 80%+ in equities in order to come close to that level of return, or you will be spending down some of the original capital.
This in turn increases your portfolio’s volatility which highlights the relationship at play here between the different factors of risk. You can’t dial all risk elements down and expect to get the returns required – it’s a balancing act between all three.
How can we mitigate inflation?
Have more growth assets in your portfolio (Equities)
This is easier said than done for the reasons mentioned above. The more equities that you hold; the higher the long-term return is likely to be. However, this will likely result in higher levels of volatility.
It’s one thing to think you will stay calm in a market correction, but actually doing so is much harder. You have to bear this in mind when constructing a portfolio, as market corrections are par for the course. They will keep happening, it’s just that no one knows when.
Investor Risk – your role as an investor
The biggest risk of all is arguably you as the end investor. This blog has touched on a few cognitive biases, or tendencies, that most investors will suffer from. However, this is by far and away your biggest risk factor.
Over the long term, the data proves to be very reliable when it comes to investment risk vs return, portfolio construction, diversification, etc. The one thing we cannot account for is the behavior and decisions of the individual investor throughout their investing lifetime.
The inherent risk of a portfolio with 60% equities and 40% bonds is made to be entirely different from one investor to the next. Understanding what makes a good investor as well as a good investment will be key to your long-term success.
Key an eye out for our upcoming post of cognitive biases. It will show some of the investing mistakes that you’re going to want to avoid and tips on how to be.