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By Caroline Ritchie, Owner of Investment Stuff
Investment risk is often defined as ‘the probability that the actual return is going to be different from the expected return.’
The higher the risk, the greater the chances that the investment might surprise you, by either increasing or decreasing in value more than you expected.
The lower the risk, the better the odds that the investment will perform as promised. The more uncertain an investment outcome, the higher its risk level.
Investors demand to be compensated for putting their money into higher-risk areas, so as the level of risk increases, the bigger the potential pay-off needs to be.
High versus low risk
In New Zealand, placing cash into a term deposit with one of our major trading banks is a very stable option. Barring some enormous global catastrophe, the bank will repay you your initial deposit, plus interest, on the exact date it says it will.
The risk level of this kind of investment is low, because the likelihood that the bank will follow through on its promise is extremely close to 100 per cent.
On the other hand, say you were tempted to buy a single, small gold-mining stock. Imagine the company hasn’t actually found any gold yet, and is operating in the war-torn Third World.
The chances of you getting your money back – or making any money at all – are highly volatile. You may lose all you put in, but you could potentially make 500 per cent or more.
Risk is not static. It’s important to remember that the level of risk in an investment may change as time goes by, either up or down. Your needs, as you move through your life as an investor, will also change. A central part of successful financial planning is to match up the appropriate risks, at the right times, for each client.
Risk is a personal thing
One of the most important and often overlooked parts of risk is your personality. Psychological research shows we’re born with certain personality traits. The ‘big five’ are our degree of openness to experience, conscientiousness, extraversion, agreeableness, and neuroticism. These don’t change as we age, and influence all aspects of our lives.
‘Openness to experience’ determines how you feel about the level of risk in investments. Individuals who are highly open to experience tend to be the ones who bungy-jump off tall buildings. They also get rich – and go broke – multiple times. They tolerate life’s ups and downs very well and can also withstand higher risk in their financial lives.
If you’re not so open to experience, the idea of hiking up Mt Everest without oxygen or living in a yurt in Mongolia for three months might be horrifying. You might also find that the thought of losing even one dollar too much to take.
So how you feel about risk is a direct result of your personality, which is pretty much set in stone. This isn’t a surprise, but it can be overlooked. Some advisers are tempted to assume everyone of a certain age and stage should have the same risk level.
The risk paradox
For most investors, ‘risk’ is going to mean ‘the chance of loss’. And your tolerance to risk will be determined by how you react to these losses.
A typical question advisers ask before placing clients into a portfolio is: “How would you feel if your investment dropped by 10, 20, 30 per cent in one year?” The difficulty for any new investor is that you can never know how you will feel until it actually happens to you, by which time it could be too late.
Even then, your guess is going to be problematic. For example, if your portfolio dropped 20 per cent, but the market as a whole lost 40 per cent, a drop of 20 per cent might look like quite a good result. If the portfolio loses 10 per cent, while the market rises 25 per cent, then that doesn’t look so hot.
Safest and riskiest investments
What’s in a fund?
In a typical portfolio, or fund, you will find four major classes of asset. In order from the lowest to the highest risk, they are: cash, fixed interest, listed property and shares.
If you put each of these four assets on a long-term chart over say, 40 years, you will find that shares have the highest total return, followed by property, then fixed interest, then cash.
It will also turn out that shares have the highest volatility, or swings in value, with cash the lowest volatility. Other special classes, such as derivatives and commodities, also exist in some funds and are up at the highest risk level, along with shares.
An investment manager will put portfolios together with differing proportions of each asset, according to the risk profile of each client. An all-share portfolio is typically called ‘Aggressive’ or ‘Growth’ on the risk scale. All cash and fixed interest would be ‘Defensive.’
A portfolio with 50 per cent shares and 20 per cent property, 20 per cent bonds, and 10 per cent cash might be called ‘Moderate’.
Different providers have their own labels, but the five or six levels of risk they offer all stem from this idea of blending the asset classes.
Why your portfolio should change as you age
Even though your inner risk-set might not alter, it pays to shift it around a bit as much as you can, to take advantage of time.
The longer your investment horizon is, the higher risk you can take, at least at the start. This is because over long timeframes, riskier investments, such as shares, for instance, will perform better overall. But in short timeframes of less than 10 years, shares can also substantially move against you.
When you’re young, with 40 years to invest, time will buffer these big fluctuations. As you move closer to retirement, the recommended course of action is to gradually de-risk your savings by trimming the shares and increasing the cash and term deposits. This leaves you less open to surprises, such as big crashes, just when you start to need comfort and security.
How to live with volatility
The biggest challenge any investor will face is watching their savings temporarily decrease in value. Shares are the most volatile, and can cause investors the most angst. If you’re new to this, you’ll be tempted to look at your portfolio every five minutes. It might even keep you awake at night.
It may be difficult not to feel anxious when you see paper losses. If you are in real distress, you are probably in a risk category that’s too high. However, for most, here are two tips to keep you calm when things don’t go your way:
1) Keep the long goal in mind. The reason you are invested is for retirement. You aren’t selling up now or, in fact, for years.
2) Stop looking! For the same reason as number 1), staring at your shares makes no difference to the outcome. Get off the computer and do something else. Look once a month, if you have to.
Common rules of thumb for age and stage are:
Age 20 to 40: Growth/Aggressive – 80 per cent shares, 20 per cent cash and fixed interest
Age 40 to 50: Balanced – 60 per cent shares, 40 per cent cash and fixed interest
Age 50 to 60: Moderate – 40 per cent shares, 60 per cent cash and fixed interest
Age 60 to 70: Conservative – 30 per cent shares, 70 per cent cash and fixed interest
Age 70 to 75: Defensive – 20 per cent shares, 80 per cent cash and fixed interest
Age 75+: All cash, term deposit and fixed interest.
It’s all about you!
Don’t forget that general rules are useful, but you can’t escape your personality! Your goals as an investor also depend on many other things: your health, life expectancy, whether you wish to leave a legacy, and what income you need in retirement.
Some investors can only tolerate term deposits for their whole lives, while others are happy with bundles of shares until they draw their last breath. There’s nothing wrong with either scenario.
The most important point is that there is no one best risk category for everyone at any given moment – it really just depends on you.