Why are we scared of risk?

So risk and volatility are entwined but shouldn’t be confused because investing in equities is not necessarily risky.

Every day we take risk; as a cyclist as soon as I get on the bike I take a risk. I can reduce that risk by introducing elements of safety (helmet, lights, reflective clothing etc) but the fact is that around 96 cyclists are killed each year.

Even car drivers take risk and around 800 car drivers (or passengers) are killed each year. On their own these figures may seem high but as a percentage of all deaths in the UK these figures are relatively low (total deaths are around 490,000).

The point is that every day we take risk, sometimes we are aware of that risk but other times we don’t consider it. Looking at the statistics, 655 people die from a “fall on and from stairs and steps”. We don’t think when we walk down stairs that we might fall and take action to prevent it, it is just something we do.

It is easy to go on but the point is that to totally eliminate all risk is impossible, because whatever we choose to do contains an element of risk. We can choose to lessen the risk but only if we know it exists.

The same is true with investing. Often we confuse risk with volatility. Risk is the permanent loss of capital, volatility is the movement in asset values.

Investment Risk

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I was always taught that the investment curve started with cash at the bottom and equities at the top with cash being the least risky. I also saw a generation that was taught that at retirement, the preservation of capital was the only way to ensure a prosperous retirement and that meant moving all assets to cash.

Over time I have felt that this is wrong but few are prepared to challenge this thinking…..yet.

We are facing a different environment of lower interest rates, lower inflation, and lower returns. In a recent Barclays study they indicated that returns on cash would be around 0.5%, bonds 2 to 3% and equities 5% to 7%. If inflation is 2% then both cash and bonds have the potential to be highly risky assets.

To explain, risk is the permanent loss of capital. With cash if I invest £1,000 and have £1,000 in ten years’ time then I haven’t lost any capital. So where is the risk? The risk is inflation – if inflation is 2% and interest is 0.5% then I am effectively losing 1.5% of the value a year. The same is potentially true of bonds.

It is easy to understand the old thinking around low risk assets especially when life expectancy was short. You retired at 65 and if you lived to 70 that was good. The reality is that now people live into their eighties and nineties, and therefore the money has to last longer and work harder. To hold in cash for 25 years has to be questioned as a sound investment strategy for many.

Investment Volatility

Investment volatility is different to risk in that it is the movement of asset values at any point in time. Cash and bonds have low volatility because the asset value doesn’t move much. In terms of cash the capital is protected (unless of course the provider goes bust and you are only covered up to £85,000 of your cash deposits (by the FSCS)).

With equities the movement in share prices can be extreme. We have seen the sudden falls in 1987, 2000 and 2008 but we have also seen sudden spikes and this is volatility.

However, if we take a single share there could be risk as well as volatility. If a share price is cheap then an investor may purchase that share because they believe it will recover and they will make a significant return. That investor also needs to accept that the share price might not recover and the company could fold (Woolworths and others) and therefore there may be a permanent loss of capital. The price changes daily and it could be significant which is volatility. So holding a single share can be risky and / or volatile, but holding a basket of shares lessens this.

So risk and volatility are entwined but shouldn’t be confused because investing in equities is not necessarily risky.

Balancing risk and volatility

There is a perception of risk that needs changing.

Research shows that over the long term equities are the strongest performing asset class in terms of returns and if we consider people living for 25 years in retirement then surely this should be considered. However, fear plays a part – a fear of losing some or all of the capital, and therefore the idea that the only way to protect that is cash. Though it should be said that a proportion if your assets can held in cash or cash equivalents (just not all of it).

There are ways to lessen risk and volatility – some examples may include:

  1. Diversification – this is basically mixing equities with bonds and cash
  2. Purchasing blue chip stocks which are likely to be less volatile (but can offer lower return potential and blue chip can fall out of favour…..banks, food retail etc)
  3. Investing in a fund where a manager chooses a basket of equities

This isn’t exhaustive and investors may mix two and three with bonds and cash.

Conclusion

Every day we take risk and yet with investments we are taught wrongly about how to consider risk. Risk with investments is about the permanent loss of capital, volatility is how assets move in value on a daily basis. To get returns above inflation in a changing world means that how people invest must change otherwise they will lose money through inflation and drops in ‘purchasing power).

The level of ‘risk’ / volatility will depend on what returns someone is looking to achieve and how much ‘risk’ / volatility they are prepared to accept.

As an end thought, the lottery takes place twice a week and costs £2 a time (£208 a year). The chances of winning are 1 in 14 million. Over 15 years if I invested this (rather than playing the lottery) with a 5% growth rate I would get back £4,500. If I don’t and I don’t win the lottery I will have lost £3,120. The question to consider is what carries the greater risk…….

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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