“Risk comes from not knowing what you’re doing.” Warren Buffett
When setting up an investment, a key consideration is how much investment risk to take. But what is meant by risk? What initially seems to be a relatively straightforward topic quickly becomes more complex when considering the many definitions.
Volatility risk
In the investment world, the terms “risk” and “volatility” are often used interchangeably. An investment’s volatility is measured as standard deviation: the degree by which an asset’s return deviates from its mean average, expressed as a percentage. Or, put more simply – how bumpy is the rollercoaster ride?
Volatility is often deemed the most significant type of investment risk; but paradoxically, this stance can pose risk in itself. To let fear of volatility determine the investment outcome – with a potential compromise in long-term growth – is a common investment mistake.
The main risk posed by volatility is that of invested capital being drawn (sold) at a loss. History tells us that, once a well-diversified portfolio of stocks and shares has been held for at least five years, the likelihood of value being less than the starting value is greatly diminished. This means that volatility poses most risk to capital in the short-term. In the same vein, volatility can cause detriment for those who are drawing on invested capital on a regular basis. If a withdrawal is taken at a low point in the market or if a loss is crystallised, the remaining capital will need to work extra hard to recover its value.
Of course, the main driver of market volatility is collective investor sentiment. “The market” – which is a product of human psychology – oscillates between optimism and despondency, with an invariable overshoot each way. A calm and measured focus on the pendulum’s average, long-term movement is one of the secrets of successful investing.
When assessing how much volatility is sensible to take, considering a timeframe is crucial. Using past data as a guide, global equities have delivered greater long-term compounded returns than cash, fixed interest (government and corporate bonds), commodities and property. It could be argued, therefore, that there is risk to growth potential by not exposing capital (that is earmarked for the long-term) to global stocks and shares.
Albeit it should be remembered that past performance is no guarantee of future returns.
Inflation risk
Inflation poses a significant risk to capital and income, although it can be easy to ignore in the short-term.
Inflation works slowly and silently, chipping away at real value – or spending power – overtime. Whilst cash deposits may feel safe in the short-term because the value doesn’t go down, holding too great a proportion of wealth in cash can present significant exposure to inflation risk. The Bank of England’s inflation calculator shows that you would now need £174.86 to buy equivalent goods and services that £100 could have purchased in 2004.
That said, cash plays an important role as a contingency fund and for short-term spending. As a rule of thumb, we suggest holding three to six months’ worth of regular outgoings in cash, plus amounts to cover likely one-off expenses in the next few years. This approach reduces the chance of needing to draw on invested funds at a lower value than you would like.
Diversification risk
In simple terms, diversification risk is about “eggs and baskets”. By investing in a range of asset classes, sectors and geographical regions, the dependency on any of these areas is diluted. Further diversification can be introduced in the form of different fund and portfolio management styles – for example, active management and index-tracking, value and growth.
A typical portfolio recommended by Menzies Wealth Management offers exposure to thousands of stocks across the globe, with access to both active and index-tracking fund management.
Summary
No risk is an island. By staying in bed, you would avoid the risk of being run over, but would inevitably be exposed to the risk of physical decline. In the same way, no one type of risk should be considered in isolation. Reducing one risk exposure can increase another. The key is to consider what risk means to you, how your objectives could be impacted, and which balance of compromise is most comfortable.
At Menzies Wealth Management, we work with our clients to fully understand their attitude towards risk, their ability to withstand investment loss, their need to take risk to meet objectives, and their knowledge and experience of investing.
Disclaimer
The information provided is for general information only and is not intended to address the particular requirements of an individual or business. It does not constitute any form of advice or recommendation by Menzies Wealth Management Ltd and should not be relied upon by individuals in either making or refraining from making any financial decisions. Where necessary, you should seek appropriate professional advice before acting on any of the information provided.
Past performance is not necessarily a guide to future performance. The value of investments and the income derived from them can go down as well as up. Investors may not get back the amount they invested.
Menzies Wealth Management is authorised and regulated by the Financial Conduct Authority (486548). Registered address: 1st Floor, Midas House, 62 Goldsworth Road, Woking, GU21 6LQ Registered in England and Wales 06597008.
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