|We are too frightened of financial
risk. Over the long term, not taking risks is riskier than taking
What does risk mean to you?
If you go to an IFA for general advice you will (or should) have
a discussion about your attitude to risk. You may fill in a questionnaire
using terms like "high" and "medium" risk, or "growth" and "value",
or enquiring as to your attitude to a 20% drop in your portfolio
value. You may feel that neither you nor your advisers are really
getting to grips with the issue, but on the other hand you don't
know how else to approach it.
Why are we frightened?
We are all too frightened of risk.
We live all the time with the
remote, but positive, chance of some catastrophe that will significantly
damage our lives: air crash, debilitating illness, loss of a loved
one, accident in the home, and on and on.
None of this is pretty, but
we live with it and even embrace it. We drive cars, walk in cities,
swim in rivers, eat questionable substances from street vendors,
allow our teenage children to go out without a police escort and
generally tempt the gods of chance every day.
And yet when it comes to the
management of our long-term savings we become paralysed with the
familiar combination of greed and fear. Mostly fear.
Financial theory says.....
We are taught to believe that there is a risk-free
financial option, called cash (or government bonds - much the same).
It may not be very exciting, but at least it's safe. Investment
theory refers to the return on cash as a "risk-free return".
.......but finance is about money, not value
Money is useless. It's what money can buy that
has value. We don't want money. We want a roof over our heads, healthcare,
food, the well-being of our families. At the next remove we want
a car, foreign holidays and golf-club membership.
And because of inflation we
cannot guarantee that a given amount of money can give us those
things a long way in the future. Because we do not know what the
money will buy.
Why give up value to save money?
So, if nothing is safe, and equities return 7%
long term (real terms, meaning adjusted for inflation), and the
risk-free rate of return (real) is 3%, how comfortable are you about
giving up this premium of 4%? [This is a historical example, not
necessarily a guide to the future]
Do you understand the magic
If a risk-free fund and an equity fund achieve their average returns
for a number of years, the following will be true:
- After 10 years, the equity fund will be nearly
50% bigger than the risk-free fund.
- After 20 years, the equity fund will be more
than double the size of the risk-free fund.
So, even on a ten-year view you can afford for
a third of your equity picks to go bust so long as the rest do only
average. Over 20 years you can afford for half of them to go bust.
That's a pretty heavy penalty you can afford to carry before you
come to regret your "risky" option. (And so long as the
'average' in the future is good enough - don't get carried away
What advice do you need?
No need to be embarassed that you cannot answer
questions on your attitude to risk. Many such questionaires are
A good adviser should probe your life aims,
and your attitude to falling short or exceeding them. He can then
help you to find an investment strategy with the right risk profile.
Or you could use our Asset Allocation models in Risk/Return
This is a long, long way from the traditional
approach: "Medium risk, guv? Got just the thing for you, this
one's flying off the shelves".