Let’s talk about investment risk - and how to effectively manage it

Choosing your baskets for investment | batjaket - stock.adobe.com

Let’s take a look at something familiar: “The value of investments and the income from them may go down as well as up and you may not get back your original investment. Past performance should not be seen as an indication of future performance. Capital at risk.”

How do these words, a standard disclaimer, make you feel? Did you actually read them? Perhaps you recognised them and skimmed over, thinking “Yes, yes, I know this because I take regular financial advice.” (Hallelujah!)

But, if you imagine reading them for the first time, how does it make you feel about investing your savings?

Here is the challenge the UK Government faces in its push to encourage people to invest for their long-term financial security – especially to provide income in retirement.

Tom Ham | Supplied

As planners we are adept in helping people understand investment risk in a productive way. Risk isn’t the enemy of building financial security. When risk is harnessed properly and over time, it becomes the engine of security. People tend to conflate volatility with risk, treating temporary market fluctuations as permanent threats to their overall financial position. We devote considerable time to talking about risk with clients at the beginning of the adviser-client relationship and at key decision-making moments.

Our role isn’t to eliminate risk. Instead, we help clients understand it and get more accustomed to it. We put it in context with graphs showing market falls and recoveries. We align risk with their goals, showing how much – or often how little – risk is involved in building the life they want. Most importantly, we show how risk preferences and tolerances might change across their lifetime.

The relationship between time and risk couldn’t be more significant. Broadly, the more time you have on your investment horizon, the more risk you can take on and still sleep at night.

There is a time to focus on growing capital, taking on risk. And there’s a time to focus on preserving capital when you might reduce risk. Increasingly over the past decades more and more people are in the fortunate position of being able to do both at once, especially as they approach and enter retirement.

One of the ways we help clients manage risk is to organise their money into “buckets” that meet different needs at different times. The timeframes given below for each bucket can be tailored to fit a client’s comfort level.

The first bucket sits in cash, covering one to three years of living expenses. This is for immediate peace of mind and offers protection from market storms.The second bucket is for expenses that may arise over the course of the next three to seven years, including lump-sum buys such as a new car or special holiday. It may hold a balanced mix of bonds and defensive equity funds to beat inflation and protect value.

The final bucket is to provide income for a timeframe beyond those seven years. This third bucket can maintain higher equity allocations to provide long-term growth and feed the other two buckets. This provides a safety backstop –an emergency fund – but it is also where value is gradually accumulating. Paradoxically, it is also where you could carry the most risk.

When you see that your immediate needs are protected, you can become comfortable with appropriate risk-taking in your longer-term investments. With this model, an adviser’s job becomes less about finding the overall risk level for an individual than about matching different risk levels to different goals and timeframes.This way of structuring things can be applied to clients at any stage of life. Whether you’re a 35-year-old teacher, a business owner approaching retirement, or an engineer who’s already retired, the basic contours of a ready-access fund, a middle-term store protecting from inflation, and a well-stocked cellar growing in value year by year will provide you with peace of mind.

So, returning to that risk disclaimer – there’s a lot of explanation that goes into helping people understand what risk means and how it applies to their individual circumstances. That’s why it’s there, of course. It’s important to harness investment risk rather than fear it, and we help people take the right risks at the right time in the right amounts.

Read the disclaimer again: “The value of investments and the income from them may go down as well as up and you may not get back your original investment. Past performance should not be seen as an indication of future performance. Capital at risk.” How do you feel?

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