If I asked you what you thought investment risk was, there’s a good chance you will say it’s the chance of you losing money.
Research commissioned by Scalable Capital and conducted by YouGov in 2017 found that a Cash ISA was the most popular savings vehicle after the workplace pension.
When asked what put people off investing in the stock market, the most popular answer was “scared of losing money.”
A fear of losing money when investing is also a common feeling I have seen in new clients I have met over the last 10 years.
Strangely, as Financial Advisers we are taught to use risk scales that measure a different kind of risk, volatility.
At the bottom of a traditional risk scale you have investments that are less volatile like cash and bonds, and then as you go up the risk scale you have investments like global stock markets and emerging stock markets.
The thing is, if you perceive investment risk as losing money then you will likely look at the lower, ‘safer’ end of the traditional risk scale. However, what you have really done is reduced the volatility of your investment by reducing your allocation to the global stock market.
You now have a different set of investment risk problems.
Types of investment risk
There are essentially three types of investment risk.
- Volatility.
- Inflation.
- Loss of capital.
Volatility is the fall and rise of your investments. Investments that have a high level of volatility will fall and rise by much higher amounts than an investment with low volatility.
Think of a roller coaster, a kids roller coaster would resemble low volatility, not many ups and downs and certainly no crazy loops. Whereas an adult’s roller coaster might go loop the loop all over the place. This would be high volatility.
Inflation is the rising prices of goods and services over time.
According to the Bank of England’s Inflation Calculator, in order to purchase the same item today that cost £1 in 1960, you would need £23.55. Meaning inflation has averaged 5.4% per year over this period.
Inflation erodes the purchasing power of your money over time and is a huge risk. Do nothing with your money and you just become poorer and poorer even without spending.
Finally, loss of capital, the big one that people perceive as being what investment risk is all about.
Loss of capital means you lose your money. There is no chance of getting it back from the investment you made. Think businesses going bust, scams or a house destroyed without insurance.
Loss of capital is certainly the most important investment risk to watch out for and avoid, especially with your family’s life savings.
So, it’s important you understand how different investments are impacted by the three different types of risk.
There are actually further subsets of risk like liquidity risk, credit risk, concentration risk etc but they are all linked to one of the main three risks described above.
Where you need to be investing to avoid the most dangerous investment risk
So, the concept of this article is all beautifully explained in videos from Andy Hart and George Agan who are both Financial Advisers.
Andy has come up with the ‘Informed Risk Scale’ which is something every investor needs to know.
Essentially, what you think might be safe from an investment risk point of view is actually quite risky and what you might think of as a risky investment is actually safer.
Let’s look at two investment examples.
Firstly, cash.
If you hold money in a cash savings account you would probably believe that there is very little investment risk, if any. Yes, the bank could fail but there is the Financial Services Compensation Scheme that protects the first £85,000. So, no loss of capital.
The amount of cash in your bank account never goes down (unless you spend it) so there is no volatility risk.
But, what about inflation risk?
The picture below shows inflation as measured by the Retail Price Index (RPI) over the last 10 years compared to the Bank of England Base Rate.
Inflation has been running at a higher level than cash interest rates. This is basically showing that your money is losing and losing its purchasing power as the years go by.
So, whilst it might not feel like there is a chance of loss of capital with cash, you are pretty much guaranteed to see the ‘real’ value of your money slowly decline over time.
Cash should only be used for the short term and emergency savings.
In our second example let’s look at global equities.
If you were to invest in a single share or shares of one company then there is always the chance of that company going bust and you losing all your money.
The same could also be said of something that’s new like Bitcoin and other cryptocurrency. It’s new, it’s unproven, no one knows where it’s going to go. It could be worthless in years to come meaning a permanent loss of capital.
But if you invest in a portfolio of globally listed companies, the great companies of the world, there is pretty much zero chance of every company in the world failing. If they all do, we have worst problems to worry about. Think Armageddon, World War three.
So, the global stock markets will be volatile, they will go up and down as different events impact share prices, but over the long term they have always beaten inflation.
Look at RPI inflation vs the global stock market over the last 10 years.
So, going back to risk scales, if you pick an investment portfolio on the lower, ‘safer’ end of the traditional risk scale, remember that the risk measurement is volatility not loss of capital.
If you go low risk your portfolio will end up more weighted to cash and bonds and less to global stocks. You may have reduced your volatility and avoided loss of capital, but you are now fighting against inflation.
Whereas go up the risk scale and you will have more of your investment weighted to global equities where there is no loss of capital, will beat inflation but will be more volatile.
Remember, volatility doesn’t lead to losses. Losses only come from volatility if YOU decide to sell. Going back to the roller coaster, you are strapped in. There is virtually no chance of you being injured whilst on the ride even though it might be a bit scary. But if YOU were to unstrap yourself halfway round then that’s when your problems start.
Volatility is only bad if it forces you to sell because you can’t handle it. Some people don’t like rollercoasters and can’t handle volatility and that is fine. But don’t avoid it because you are worried about losing all your money. Volatility will never lose you money, it’s how you react to it that can cause you to lose money.
We recently did a webinar on the Two Techniques That Will Increase Your Pension Value And Boost Your Retirement Income. You can watch a recording of this below and if you still have more questions or need help getting your retirement sorted then please contact us for a free no obligation chat.
Risk warning:
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.
