Investors and investment risk
All investment involves risks in some form or other. Even an investment in a Government bond is subject to the risk that inflation will erode or possibly even cancel out the nominal return. Different investors each have their own level of risk that they find acceptable.
The adviser's fact-find process must discover a client's attitude to risk. This might well take some time, especially if the client is not familiar with investment issues and has little or no experience with financial planning. The main risk for clients is that they will not achieve their objectives. People have different objectives at different times in their lives and often have several objectives that sometimes compete and conflict with each other. So risk can be complicated and multi-dimensional.
Different types of risk
It is increasingly recognised that there is no single spectrum of risk and that financial risk has several dimensions and aspects. One of the key tasks of financial advisers is to alert clients to the various risks they face in each of the investment and financial decisions they make or, in many cases, they fail to make.
Different types of investment are more or less risky in different circumstances.
Inflation erodes monetary values, so cash and fixed-interest securities are very vulnerable to inflation.
In an economic downturn, equities are generally losers.
In periods of declining interest rates, cash deposits are generally unattractive while fixed-interest bonds and very often equities can be more appealing – witness the strong performance of bonds and shares in the 1990s.
Determining an investor's risk profile
It is of paramount importance that an adviser should understand an investor's risk profile with respect to their intended investments. Often, it is far from being a simple issue that a client is low risk or medium risk, especially if the client does not understand the practical implications of those expressions in terms of the types of investments that are suitable for them.
A number of factors are likely to affect a client's risk profile and they will include:
Objective factors such as timescale, age, family commitments, income and assets.
Subjective factors such as attitudes, instincts and experience.
An added complication is that there may be more than one single risk profile to be considered.
A specific fund for school or university fees may need to be considered in a different way from the provision for retirement.
An investor and his or her partner may have conflicting views and different objectives. They may need to be advised separately.
The trustees of a trust are likely to have aims, objectives and attitudes towards the investment of trust funds that would be quite different from the approach they take to their own money.
Timescale and risk are closely associated, especially with asset-based investments. Traditionally, it has been true that the longer the investor can stay invested or wait for markets to recover from low points, the more chance there is of avoiding a capital loss.
Real growth in equity values is a function of sustained and sustainable economic growth and wealth creation by the companies whose shares are held. This cannot be expected to materialise in just a few years. Consequently, an equity investment held over one or two years is very much riskier than an investment held for a period of five years, which in turn is more risky than an investment held over a 10-year period.
Based on Barclays Capital statistics for the 20th Century (see graph above), the probability of equities beating deposits was 68 per cent over two years, 77 per cent over five years and 92 per cent over 10 years.
However, timescale needs to be treated with caution as seemingly rare events can and do occur. For example, 2002 marked the third consecutive year of falls for the UK equity market. The last time such a run of losses occurred was between 1960 and 1962.
As clients grow older, they are generally less willing to take capital risks because they cannot easily replace through earnings any money they lose. In retirement, this is compounded by lack of earnings and the possibility that death will occur before a market recovery.
An interesting demonstration of how the appetite for risk reduces with age is the rough rule of thumb used by some advisers that the proportion of a portfolio held in bonds should equal the investor's age. On that basis, an 80-year-old should consider keeping 80 per cent of their investments in fixed-interest securities.
Clients could be reluctant to take capital risks if members of their family might suffer as a result. They may feel a particular need to protect against inflation risk, for example, when setting up arrangements to fund education.
Income or assets
Clients with relatively little income or capital can generally afford to take on less capital risk than wealthier investors. A £10,000 loss to a millionaire is 1 per cent of capital but to people with total savings of £20,000 it is half their wealth gone.
It is not just the objective factors of timescale and so on that influence the way in which an investor will approach decisions about investment risk. There are also some very important subjective factors:
General attitude to taking risks, Some people are psychologically more prepared to take risks than others,regardless of their circumstances.
A person with investment experience might find it easier to take decisions. Knowledge of investments can also help.
When are fixed-interest securities likely to perform poorly?
A: When inflation is rising.
B: When interest rates are falling.
C: When the economy is stable.
D: When equities perform well.
Timescale, age, family commitments and income/capital wealth all influence an individual's attitude to risk.
What is the normal effect of increasing age on an investor's attitude to risk?
B: The appetite for risk increases.
C: The appetite for risk reduces.
D: It depends on the investor.
Answers to self-test questions
Rising inflation reduces the real value of future income payments and therefore depresses bond prices. Nominal performance may be acceptable, but real returns can be negative. For example, in the 1970s, the nominal annual return on gilts was 8.5 per cent but the real return was -4.2 per cent a year.
Appetite for risk normally reduces with age because the investor has less time and/or ability to replace any losses made.
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