Nowadays, unless you feel skilled and confident picking different companies to invest in, it is highly likely you will pick a pre-built portfolio using an investment risk scale.
This way all the investment management is done for you.
When choosing your investment portfolio you will usually be presented with an investment risk scale that might use different descriptions like ‘cautious, ‘balanced’ and ‘aggressive’. Or numbers might be used like one to five or one to ten.
Regardless of the investment risk scale used, the portfolio you choose is going to have a massive impact on the type of retirement you can enjoy so it’s vital you understand how to use them.
Understanding an investment risk scale
An investment risk scale is trying to measure two things:
- The volatility of your portfolio – the falls and rise in value.
- The likely returns you will get – higher or lower returns.
Where a portfolio sits on an investment risk scale will largely depend on how much is invested in bonds (a form of loans to governments and companies with a fixed rate of interest) which are generally seen as ‘less volatile’ and equities (shares in listed companies) which are considered ‘more volatile’.
The more your portfolio is invested in equities, the higher up the investment risk scale it will be.
It’s worth stating at this point that when using a well-diversified portfolio, investment risk is never about losing all your money.
For example, our own range of investment portfolios typically invest in 7 funds which in turn invest in around 28,000 individual equities and bonds.
So there is basically zero chance of losing all your money from investing alone. What you will see however is volatility. Your portfolio will go up in value and sometimes down in value.
As a firm we use a risk scale of one to ten. With one representing the lowest, stable returns and ten representing the highest, volatile returns.
Here is an example of the volatility of our risk level three portfolio over the last five years using actual performance data:
Here is a risk level ten portfolio:
You can clearly see that when markets decline, the volatility in the risk level ten portfolio can be scary.
So you might base your investment portfolio decision on volatility alone. As in how much of a scary ride can you take?
But that could be a mistake. You see, the longer you have to invest, the more time you have to recover from market declines and see more growth in your portfolio. If we look back over the last 100 years or so the capital markets are up 75% of the time and down 25% of the time.
The chart below shows our ten different risk rated portfolios in order, with the first being lowest risk and the last one being highest risk as measured by volatility.
We have gone back and looked at the last 100 years of capital market data and found the best one year returns and the worst one year returns.
You can see that as expected the higher up the investment risk scale you go the more chances of suffering a really bad fall in any particular year.
However if you extend the investment time period to 20 years, and bear in mind a person retiring at 60 could face at least a 30 year retirement, you can see that the risk scale turns on its head.
We can now see that over rolling 20 year periods over the last 100 years, the annualised returns in the worst years are still positive for the higher risk portfolios and negative for the lower risk portfolios.
So the data is telling us that if you are investing over the course of your retirement, you have more chances of suffering a loss after inflation is factored in if you choose a lower risk investment as opposed to a higher risk investment.
So should everyone be at the top end of the investment risk scale?
Well there is overwhelming evidence that supports the view that the longer your investment term, a portfolio more weighted to equities will achieve better returns than one more weighted to bonds.
However, there are three factors that you need to consider before choosing a portfolio from an investment risk scale.
#1 – Your need to take risk
Do you actually need to take any investment risk at all?
After all, if you can achieve all of your retirement goals without taking any risk why jeopardise things? Although remember, inflation is one of the biggest risks of all.
In order to work out what risk you need to take you will need to understand what you want to do in retirement, how much this will cost and whether your current retirement savings can afford it.
#2 – Your attitude to risk
If we were all robots then choosing the highest risk portfolio should deliver us the best returns over the long term.
But we are not robots and instead we are going to find it very scary when we go through periods of market decline and see our retirement savings fall dramatically.
It will tempt many of us to sell to stop the losses and this action could wreck everything.
#3 – Your capacity of loss
Following on from point two above, when markets do decline and you need cash, at what point is the fall so bad that it starts to impact on your daily living or worst look like you will run out of money.
You might need to take risk and you might be a very adventurous person being able to withstand lots of volatility however, if you don’t have enough retirement savings at the start to weather the storm then you are going to run out of money.
Choosing your investment portfolio from an investment risk scale may seem simple but as you can see there is actually a lot to it and making the wrong decision could really mess up your retirement.
A good Financial Planner will guide through each step so that you end up with a portfolio that will deliver the return you need at a level of volatility you are comfortable with.
If you would like to understand how much you need to be able to afford the retirement you desire please schedule a no obligation free 15-minute call.
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.