Investing, investing, investing and risk……

Investing seems like one of the easiest things to do……we read the papers, we see the case studies and everyone makes money…

Combine this with saving money by cutting out the middle man (financial planner) it makes perfect sense that direct platforms are enjoying a halcyon period of growth.

Of course this picture is beautiful especially when the markets are going up. But when the ‘unknown unknown’ happens and the markets go down this tests even the most seasoned of investors.

The problem with seeing things through rose tinted glasses is that they don’t display the full picture – what many forget is that by cutting out the middle man they take on the full responsibility, not only of their financial plans but also the investing of the assets used to deliver those plans.

Whether we choose to manage the money ourselves, or decide to go to a financial planner, investing can be risky if we don’t fully understand what we are doing.

A jumbled mess

portfolio desion 2014This diagram best describes what many of us have as investments if we don’t get it right, and what we should have if we do get it right

The types of questions we should be asking ourselves include what is our approach to investing? When do we need the money? What is it for? And can we stomach short term ‘loss’ for long term gain?

What this is doing in a simplistic way is identifying our tolerance for risk. For example, if we needed to pay a tax bill of £4,000 next month then it is highly likely that we could not tolerate any short term loss because it would mean we couldn’t pay the tax bill (and we know how grumpy HMRC gets).

However, if we consider a longer time frame of say 20 years with a goal of delivering a fund for retirement the tolerance for short term ‘loss’ (often referred to as volatility) is possibly more palatable.

All of that makes perfect sense but how do you judge what is termed ‘risky’ and what is not?

The risk conundrum

We are hard wired to believe that if we hold cash there is no risk; bonds present a little risk, property a bit more and equities lots.

For the defensive / cautious investor it makes perfect sense to hold cash and possibly bonds (perhaps even property) and avoid equities because that way capital can be protected.

Here are some facts to consider:

  1. For over 30 years bonds have enjoyed a bull market, i.e. they have been on an upward trajectory. The last time they were in a serious downward spiral was prior to 1981, and that means very few people today were around managing money in that environment
  2. It is widely acknowledged that with the unwinding of QE, and increasing of interest rates (albeit slowly) the bull market will turn to a bear market and returns are challenging. Some believe that returns after inflation could be between 0 and 2% for the next 10 to 15 years. But we have not faced this for 30 years so actually many just don’t know and this heightens the risk for bonds
  3. Cash is a known safe haven but interest rates on cash are at historic lows and will remain at that level for some time to come. To get the best returns investors now need to manage their cash like investments, locking the money into longer fixed rate periods (where they can’t access the capital) and having to spread money across different institutions because of caps on the maximum investment. To do nothing will mean cash will be eroded by inflation
  4. Property is coming back as an asset class, but 2008 shows the risk of investing in bricks and mortar property fund, and alternatives that invest in property companies carry risks especially when interest rates rise

Many investors who think it is easy to invest don’t consider the potential risks, and this is before the ‘unknown unknown’ comes into play.

Equities, equities and equities

So if bonds and cash appear more risky than the graph shows, and we are nervous about property then what about equities?

The assumption is that all equity investments are risky. But within this there are different levels of risk:

  1. Two European Growth Funds in the late nineties – one returns a respectable market beating 20%, the other 80%. Which carries more risk? The logical answer is that the one with the highest return would carry the greatest risk (and that would be correct). Which one would investors choose? The answer is of course the more risky one because investors want the growth but don’t consider the risk. Of course the fund was full of dotcom stocks and when it went bang so did the fund…..
  2. Fast forward today……what are the risks with equities….
    • Europe in 2013 was the top-performing market, 2014 it was one of the worst
    • Japan seems broken, but is it, how do some funds get returns and others don’t
    • All of emerging markets are broken, or are they
    • The US is self-sufficient (or will be shortly) what does this mean for the global economy, or domestic stocks
    • The UK is facing a political nightmare, and what will this mean for equities going forward

The point of this is that if we act on what we know we can lessen the risk with equities. So for example, if we know the top-performing European Fund has achieved that success because of its holdings in peripheral Italian Banks then we may consider that too risky. If we find a fund that works in tandem with the changes happening in Japan and in particular a depreciating Yen then we can in theory capture greater returns and so on.

Knowing what’s in the tin

There are arguments for and against diversification of assets. Clearly if your investments are spread between asset classes, regions and sectors then you will reduce the downside risk.

But the key in diversification is understanding what’s in the tin. For financial planners it is easy to take an off the shelf solution or outsource to a third party, but unless they know deep down what is happening with the overall economic climate (and how this impacts on the portfolio of assets) I would argue that they are no better than the person who chooses to do it themselves.

It is the responsibility of the person who looks after the investments to know what they are, what they do and how they blend together.

It could be that the mixture of assets appears to be highly concentrated on equities, but within that mix there is an investment which reduces the overall risk.

So effectively it is about weaving and blending to get the end result. Going back to the diagram, a good portfolio manager (whether an individual doing their own thing, or a financial planner doing it for a client) will stay clear of the jumbled mess.

For many investors they don’t know what is in the tin and they just add to what they have with no real knowledge of the consequences of what they are doing. Equally financial planners who don’t engage with all the investments their clients hold are in danger of not understanding how the proposition will deliver the right outcome for their client.

Conclusion

Investment risk models are gradually being homogenised and therefore real risk is in danger of being ignored. You can mechanise risk through risk models but the reality is that many of these crunch past data because that is all they have, their argument is that it works – until of course it doesn’t!!!

The reality is that human intervention is important alongside tools because they can challenge conventional thinking. They can understand what is in the tin and the consequences of having the different ingredients. (Humans won’t always get it right but they have a greater chance than the mechanical models).

The point is that investing is not easy, it’s not just about picking a share or fund, it is about understanding the investments and how they will respond in different markets. Of course people can do it themselves, and some are very successful but the reality is that for many they don’t and in the long term what they save at the start is lost through irrational investment decisions.

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.

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