Rather than consider risk / reward it should be risk / return.
I recently read two fascinating pieces about cash. Both made me think that we need to have a greater understanding of this asset class.
This blog is my attempt to kick start this debate.
Cash is risk free
We all know that cash is risk free, don’t we?
But is it?
If I have £20 in my pocket, then in its purest form it returns me nothing. In fact, just holding cash actually carries risk. Firstly, I can spend it, or if I put it in the piggy bank over time the true value of that money goes down because of inflation.
To get a return therefore you have to physically do something, and this is where taking a risk comes in. Some call it reward but it is probably better to use the word return (this is important when we cover this later).
Cash is seen as the asset with no risk; and most people still think this is the case. What the financial crisis showed us was that although cash savers weren’t directly taking risks, the banks were doing this for them.
Savers were chasing high rates without questioning how the banks were achieving them, and the banks were subsidising artificially high rates. Of course when it all went wrong some banks went bust, and although many people got their money back it demonstrated that cash is far from risk free.
It is important for cash savers to understand that the days of subsidised rates are in the past and they will not come back. The financial crisis ended this and therefore in a low interest rate environment, savers must now accept much lower returns.
At the moment whilst inflation is zero this is manageable, but when inflation rises there is the potential for cash to be a negative returning asset in real terms.
Effectively savers who believe cash is risk free need to consider their options.
Risk / Reward
Financial services are guilty of having some terrible terminology and I am sure I am just as guilty of using them.
One of the worst is ‘risk / reward’ and this sparked a fascinating ‘debate’ from a speech given by Paul Lewis.
His speech was brilliant in many places and even his comment on cash was interesting but I think it sparks a ‘debate’ on misconceptions.
To quote “The idea that risk means reward is not for the benefit of customers. It is for the benefit of the product providers”.
His argument is that at a time of pensions freedom and the ability to take an income the only certainty is cash. He compares to a fund investing in the FTSE 100 over a 6-month period and classes the fall in value as a loss. This is where confusion lies.
What is risk?
If I have £20 and I lose all that money then effectively that is a permanent loss, I can never replace that. That is risk in its pure sense.
If I invest £20 in a fund and in six months’ time that fund is worth £15, but in five years’ time it is worth £30, that is volatility: which is about how the money moves up and down during an investment period. Of course risk plays a part in this and the more risk someone takes, the greater the volatility, and the potential for permanent loss of capital.
The argument that Paul Lewis uses is that someone has invested everything in the FTSE-100. The reality is that no investor should do that. Diversification across geographical regions is important, and solely investing in a fund that tracks the index is not necessarily the best investment idea.
Risk is only risk if we don’t understand the concept of investing.
What is reward?
I agree with Paul to some extent, when he says that having ‘to take risk to get a reward is wrong’ (of course his argument stalls a little because even investing in cash is risky to get a reward!)
We need to turn this around. To do nothing with money means that you get nothing back. £20 will remain £20 unless we take some risk. That risk will deliver some return. The level of risk in theory determines the potential return.
Paul argues that there are overseas cash accounts regulated in the UK which offer better returns but actually these carry greater risk than UK cash accounts, so actually to get the slightly higher returns someone is taking greater risk.
Also going back to his argument; diversification is the key. Investing in only cash or the FTSE-100 is a misunderstanding of the basics of investing.
Taking the argument further if I have a pension fund of £100,000 and withdraw an income of 4% a year from this, then I need to achieve returns of 4% plus to have a chance of growing my fund and ensuring it continues to last during my retirement. If I invested in cash paying 3% a year, then I am actually eating into my capital. Equally if I invest purely in a FTSE-100 tracker fund I could suffer the same fate.
Therefore, I have to take adequate risk to achieve that slightly higher return. This is not about rewards, this is about returns.
A lot of this has come about because of the new pensions freedom and it is worth considering this.
Taking your income from your pension fund was considered highly risky and should only be considered where specialist advice was involved. It was also felt that it was not suitable for those with a small pot of money.
The risk was that the income was not guaranteed. The only way to get that guarantee was through an annuity (where the insurance company give a guaranteed income for life).
That risk hasn’t changed but it now seems everyone is being persuaded that this is the only way forward. If we take Paul Lewis’ argument about a fear of loss of capital and therefore income, should consumers actually be considering drawing down the income from their pension fund or should they be buying an annuity?
The arguments against annuities are numerous, but can consumers really expect the same rates as twenty years ago? Of course not, many factors which are used to calculate the annuity have changed over the last twenty years (life expectancy is greater, inflation was much higher etc). Pensions freedom doesn’t remove the need for annuities, for risk averse clients there is still a place and it shouldn’t be forgotten.
Cash…what is it good for, absolutely nothing!
So how to conclude; I am not saying Paul Lewis is wrong but I think he unwraps a wider debate.
Cash carries an element of risk especially if you require the higher rates because it simply won’t meet that level. Investing in one asset class can potentially reduce the potential return, and in some cases increase the risk of permanent loss of capital.
Rather than consider risk / reward it should be risk / return.
And finally drawing an income firstly from your pension fund could be perhaps riskier now, than it was a couple of years ago. For those who are worried about this, an annuity could still be the best solution.
Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.