Risk - Are you sure you know what it means?

By FMB on 

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A bit like the word "love" or "nice", the word "risk" can be rather meaningless without any context.

We talk about risk with clients, probably at every meeting and I hope we explain it well, but it's always worth a reminder. Also, it sometimes helps to explain things in a different way, to provide a more thorough understanding.

I often wonder why people choose to invest in something they have seen advertised in a magazine thinking that it is less risky than the stock market. Here I explain how perhaps someone who has no financial experience thinks about risk and why financial mistakes might happen.

Here is a list of financial items you could choose to invest your life savings in:-

  • Shares in a single big (large cap) company
  • Commodities like gold and alternatives such as Hedge Funds
  • Cash
  • Government bonds
  • Shares in a single small (small cap) company
  • Global equity funds
  • What’s working now – what’s hot!
  • Corporate bonds
  • Property
  • Emerging market equity funds

On a scale with 1 being no risk and 10 being high risk, this is how the uninformed investor may think about risk:-

  1. Cash - “cash is king” right?
  2. Government bonds - the government are a safe bet
  3. Corporate bonds - consistent predictable income
  4. Property - bricks and mortar
  5. Commodities - a safe haven
  6. What’s working now - car parks, CBD oil, crypto-currency
  7. Global equity funds - stock markets are a gamble
  8. Emerging market equity fund - less developed countries are even more of a gamble
  9. Single shares in a large cap company – eggs in one basket
  10. Singles shares in a small cap company – even riskier

So as informed investors with a high level of financial literacy, we can look again and put some context into this list.

There are three types of risk at work here:-

Loss of capital – risk of losing literally the whole lot
Inflation – a slow erosion, drip drip
Volatility – riding a rollercoaster

Loss of capital

This is the one we really want to avoid and the three highest risk items are these:-

  • What’s working now- if it’s “hot” now it probably won’t be next week. An informed investor knows what has ALWAYS worked. Do not invest your life savings in whatever is being advertised in a magazine devised by marketers. You could very easily lose your shirt on this.
  • Shares in a single small cap company – nothing wrong with investing in companies but just one places all your eggs in one basket and a small company is riskier.
  • Shares in a single large cap company – again, even with a bigger company and a proven track record, it is far too risky and you are exposed to a high risk of loss of capital.

Inflation risk

This is something less educated investors often don’t consider...

  • Cash – is at really quite high risk of inflation when you think about it. If you leave all your money in cash with interest rates having been so low for so long, your money is worth less now than even 5 years ago. Cash is not king! Think about maintaining purchasing power.
  • Government bonds – inflation will still have somewhat of an impact.
  • Company bonds – on a par really with government bonds.

These three will have varying degrees of erosion of buying power but a low risk of loss of capital. In fact, none if you keep a limit of £85,000 in any one UK banking institution for example. It’s easy to think of them as very low risk and forget about the impact of inflation.

Volatility

Volatility on the other hand, might be something we seek to minimise but if you invest in a diversified portfolio over a significant period of time, history would show there are some assets that have kept up with inflation.

  • Commodities - can be a bit volatile but useful as a hedge against inflation
  • Emerging market equity funds mean investing in real companies selling real things to real people. The chance of a loss of all capital is almost none unless we have global Armageddon as money is spread around many companies and countries, albeit less developed ones so it’s more likely to be volatile.
  • Property has historically delivered a rise in capital and income so is a true asset class of its own. Not everyone wants to be a landlord with a second property but many people do downsize to realise some of the asset in their home.
  • Global equity funds. It’s very difficult to imagine a complete loss of capital unless we are all in very big trouble. A mixed case of the best companies in the world has historically given income and capital growth to make sure the spending power of your assets is maintained. History shows that the stock markets have delivered rising profits, rising dividends and a rise in capital.

Conclusion...

This does not mean that you must only invest in equities, at FMB we believe in a combination of strategies and really all of the items apart from those with a high risk of capital loss, play their part in a balanced financial plan. I just wanted to make the point that without the guide of an experienced financial planner, many people will have an incorrect view of risk which is why some people make the wrong choices.

Some people assume volatility is a high risk, but although it can make people nervous the main danger is jumping off at the wrong point… a bit like a rollercoaster!

Of course, I need to warn you that the value of your investments can go down as well as up, so you could get back less than you invested.

Past performance does not reflect future performance.

The information in this blog is for information purposes only and does not constitute advice. If you have any questions please speak to an Independent Financial Planner

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