Journal

Just what is ‘risk’?

Looking at the world today, it’s a challenge to see anything but risk – hardly surprising given recent atrocities and the uncertain UK political landscape of the last 12 months.

Events such as these inevitably affect the way we feel about the world. Whilst a fearful or pessimistic view is a perfectly natural short-term reaction, this doesn’t create a rational basis for sound financial planning and investment decisions.

In my experience, financial risk if often misunderstood. So, what types of risks should you be looking out for? How can these affect your money? What can you do about risk?

 

Whether you’re ultra-cautious and keep your money stashed under the mattress, or you’re highly speculative and plough everything into ‘The Next Apple’, all investments carry risk.

It comes in many forms and it’s impossible to avoid it.

Below are some of the main risks you should look out for. Which ones are you exposed to?

 

Inflation Risk

Money in the bank makes us feel safe but it’s a poor long-term investment.

Prices and costs of living generally tend to rise over time. To stand any chance of retaining their buying power, your assets need to generate a sufficient return (after tax) to keep pace with or outstrip inflation.

There’s no universally agreed inflation measure – 3% is a historically popular annual figure, as is the Retail Price Index. Others feel that inflation is entirely personal, as it depends on the types of goods and services you regularly consume. Either way, it erodes the value of cash over time.

Imagine that today you have £100,000 in a savings account earning annual interest of 1.00%.

In 2027, you pick up your savings statement and get a warm fuzzy feeling inside when you see the balance on this account has grown to £111,567*. But what your bank statement doesn’t tell you is how inflation has impacted the purchasing power of this money.

Assuming 3% annual inflation over that same period, the real value of this money is actually £79,804*.

You’d actively sought to avoid risk in this scenario but have ended up losing money anyway. Ouch.

(*Source: MoneyScope HQ)

 

Equity Risk

Along with property, shares remain the core component of an effective investment strategy, as historically, they tend to reward investors for taking risk over the long-term.

There are, however, no guarantees of investment success, as many variables can affect the performance of a company’s share price. Even the most successful companies experience periods where their shares fall in value; often for reasons beyond their own control. This is volatility (fluctuations in price), which is distinctly different from risk.

At its worse, equity risk can see you lose your money completely if a company you’re invested in goes under. You can, however, easily dilute the potential impact of such a loss by investing in a wide range of companies.

The one thing an investor must accept and expect with equities, is bumps in the road, but you need that volatility, as it creates opportunity.

 

Credit Risk

When you lend money to a person or a company in return for a rate of interest, you want to be reasonably certain you’ll get your capital back at a given point in the future.

If there’s any doubt over if or when money will be returned, an investor should expect to be compensated for this additional risk through a higher rate of interest.

This is particularly relevant for investments in government and corporate bonds (effectively loans), which often make up the more defensive aspect of an investor’s portfolio. The term of a bond, the type of borrower (government or company), their creditworthiness and base interest rates all have an impact on bond prices, yields and risk.

Therefore, if you hold or are looking to hold bonds in your portfolio, it’s wrong to assume that all bond funds are the same. Some funds will be more risky than others depending on the credit risk of the underlying bonds. It’s important to understand this particularly if you hold equities in your portfolio as well.

 

Concentration Risk

This can apply in a number of ways, but essentially refers to the risk of having too much money invested in one place.

For example, holding more than £75,000 on deposit with one banking group can be seen as concentration risk. The Financial Services Compensation Scheme won’t protect excess savings over this limit if the bank goes to the wall.

Whilst common sense suggests it would be sensible to spread a large savings deposit over several banks or move into alternative types of investments, I’ve heard many argue that no major UK bank would be allowed to fail, so don’t see the point in multi-banking.

Even in a matter as seemingly clear-cut as this, individual perceptions of risk will differ due to personal and even political beliefs.

 

Liquidity Risk

This basically refers to how easy it is to get your money out of an investment.

Is there a minimum term?

Is there a waiting period, or penalty, for early redemptions?

Is there a ready market of buyers to sell on to if you want to cut and run?

The British are pretty keen on property, so much so that many people’s retirements rely heavily on the potential growth in the value of their home (concentration risk also comes into play here).

But like any investment, it’s not perfect.

To benefit from potential long-term income and price growth, you all but give up access to your capital. Many can accept this but what about when it comes to getting your money out?

What if the market is depressed at the time you need the money? Will you have to accept a lower offer (and lower profit) to get the deal done?

 

Tax Risk

Tax can take a bite out of investment income and growth – sometimes to the point where the investment proposition starts to become less attractive.

Again, not picking on property but it’s the prime example of an investment asset whose tax treatment needs to be fully appraised.

Restrictions on interest rate relief, higher stamp duty rates and difficulty in sheltering capital gains (as well as the usual location, liquidity risk, void periods, etc), will all have a bearing on the investor’s bottom line.

 

Longevity Risk

In other words: running out of money too early.

The potential lifespan of a person’s wealth involves many variables including current net worth, pension provision, attitude to risk, market performance, and future income requirements.

The back of a fag packet approach is a popular way of calculating longevity risk but my preferred approach is cash flow modelling, as it factors in inflation and all manner of other variables. This more scientific approach provides a sound basis for making long-term financial decisions.

For me, investing without some context and real purpose can mean the longevity of your money is left somewhat to chance and the well could dry up a lot quicker than expected.

Fail to plan, plan to fail and all that.

 

Risk – Friend or Foe?

Ultimately, successful financial planning and skillful risk management is about ensuring you have the right money, in the right place, at the right time.

For this reason, individual perceptions of and tolerance for different risks will vary from person to person. It will also be dictated by their personal circumstances, income, lifestyle, family and long-term financial objectives.

Risk can be a good thing if there’s a potential carrot at the end of the stick, like equity risk.

Equally, certain types of risk should be avoided if there’s a real danger that it might conflict with your future plans e.g. liquidity risk.

If risks are always present, the best any of us can do is to try to balance these out or trade one type of risk for another where the potential outcome is more favourable.

The one thing you mustn’t lead with when considering risk is emotion. As far as humanly possible, let basic risk-reward principles guide your investment decisions, not the primal fear of loss. As Warren Buffett so elegantly put it:

‘Risk comes from not knowing what you’re doing’.

As ever, please feel free to get in touch if you need further information or advice.

Thanks for reading.

Simon Ben-Nathan

 

  • Tax reliefs are subject to your own personal circumstances and are subject to change.
  • The value of your investment can go down as well as up and you may not get back the full amount you invested.
  • Past performance is not a reliable indicator of future performance.
  • Investing in shares should be regarded as a long-term investment and should fit in with your overall attitude to risk and financial circumstances.
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