When constructing investment portfolios, it is essential that we understand exactly what we mean by “Investment Risk”.
Many, if not most, investors see risk though the lens of short-term volatility, that is to say the rapid changes in price of an equity portfolio compared to, say, a bank account.
Whilst it is true in the short-term that a bank account “seems” safer than an investment in the market, when looked at over the longer term, historically at least, the bank account has struggled to keep pace with inflation and savers have “lost out” significantly to the additional wealth created by global capital markets.
Are you a saver or investor?
The first step to establish is do you intend to consume all of the cash under consideration over a term of 5 years or less?
By consume we mean that you are saving up to purchase a car or a house. These are not investment decisions and the correct advice is to save in a traditional bank account/State Savings. You are by definition a saver.
Similarly, if you are arranging a "rainy day" fund then, again, despite historically low interest rates, the correct answer is a traditional bank account/State Savings as we set out in our analysis here
If, however, you do not intend to consume all the capital in the short-term, then by definition, you are an investor. Now, you might be a cautious, nervous or risk-adverse investor, but you are non-the-less an investor.
You are not “saving for your retirement” you are “investing for your retirement” and short-term volatility should never be a consideration for anyone accumulating with a long-time horizon.
Bank or Financial Adviser risk profiler
However, we frequently see examples of investors taking financial advice which places all of the emphasis on their attitude to risk.
This is typically measured by way of a risk profile questionnaire which provides a risk score and therefore a “recommendation” for a suitable investment.
Whilst your attitude to risk is a consideration in the suitability process and indeed is explicitly referenced in the consumer protection code, it is a mistake to believe that it is the most important factor.
Our Financial Personality Framework delivers unique client insights. It uses behavioural finance (combining behavioural and cognitive psychological theory with conventional economics and finance) to give you robust insights into how your portfolio should be constructed in line with expectations and composure levels. This reduces the risk of you abandoning your investment strategy at inappropriate times.
“The investors chief problem and even their own worst enemy is likely to be themselves
Ben Graham, mentor to Warren Buffett
Our risk profiling process distinguishes three distinct elements of risk
- Your Risk Capacity – Your objective ability to bear investment risk
- Your Attitude to risk – Your willingness to bear risk
- The Required risk – The level of risk consistent with your goals and objectives
In our view, these three areas MUST be dealt with through a separate and distinct analysis in order to provide the necessary variables to consider when developing any investment strategy.
Example - Differences in capacity to tolerate risk.
Let's consider the fate of three investors who each see a 50% drop in the value of their portfolios.
- C. Montgomery Burns - Mr. Burns is over 100 years old and has made billions as a captain of industry. According to Forbes Magazine his estimated net worth is $16.8 billion.
- Homer Simpson - Homer is in his late-50s and works as a safety inspector in Mr. Burns' nuclear plant. He has a family to support and is slowly nearing retirement. We'll be generous and give him a retirement portfolio of $100,000.
- Bart Simpson - At age 10, Bart is just beginning his investment career. His current net worth is $500.
A loss of 50% would drop Mr. Burns down to a paltry $8.4 billion. While Burns would no doubt be incensed at the loss, $8.4 billion should still be sufficient for his needs given his age. Bart, too, has the capacity to absorb a financial hit of 50%. He has many years to continue saving and investing before he needs to think about retirement.
Homer, however, does not have the financial capacity to tolerate risk, even though he might be more than willing to gamble it all away on some ill-conceived risky investment. He has a family to support and about a decade left until retirement. A 50% drop in the value of his portfolio would be potentially crippling.
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