Investment and risk

If you don’t know your pension fund’s investment risk,
this page should encourage you to ask.

Investment risk is necessary, just don’t over do it

Spreading your money across a broad range of investments
helps reduce risk

Simple Facts about Money

If you left your money in a bank deposit it would fall behind inflation.

Your money would lose value

If your invested money grew by the rate of inflation every year, it would always buy the same as it did when you started.

Your money would keep its value

If your invested money grew by more than inflation you would have real growth above inflation.

Your money would increase in value

This is particularly important when you stop earning, because the savings you have on retirement need to be protected from annual inflation increases. Unless your money grows by inflation, it will buy less as time goes on.

Bank Deposit Accounts -v- Investments

WHAT IS THE DIFFERENCE?

Deposit

Deposit accounts & most cash ISAs are for short term, they pay a rate of interest. Deposits are good for daily spending, or for a fixed amount of money you need at a future date when timing is vital. Money on deposit will lose buying power as it falls behind inflation. You are effectively ‘lending’ it to the bank, they may pay you a fixed or variable interest rate in return.

bank takes the risk

The bank has full control of how they invest or lend out your money and they keep the profit.

investment

Investments and Investment ISAs give a variable return for the medium to longer term. Investing savings builds long-term wealth and financial security. Money invested can maintain buying power as it can equal or beat inflation.

you take the risk

Invested money by-passes the bank. You have full control of your money and you keep the profit.

Understanding managed funds and risk

Most pension schemes choose a medium risk, where money is BALANCED across a variety of investments.

Risk here is measured from 1 to 10, 1 being lowest and 10 highest. A medium risk would be 5.

These graphs illustrate how to spread your risk across different types of investments or ‘asset classes‘. to show how risk can change over the short and long term.

Here are two real, but unnamed funds chosen because of their diverse investment styles, (these are actual figures). One is ‘lower risk 2′ invested in Bonds or Fixed Interest Securities. The other is ‘higher risk 7′, invested in Global Equities. Each of these funds is managed by a ‘fund manager’ and contain the manager’s choice of investments.

Graph 1

This is a 6-month period from July 2019 to January 2020 when markets were down. You can see that both funds achieve the same result (4.3% growth), so you maybe more likely to choose the lower risk fund.

Graph 2

These are the same two funds, again over a 6-month time period, but ending 6 months earlier in July 2019 when the first graph started. I guess you might choose the higher risk fund this time.

Over the long term the higher risk fund would have given you more growth because it’s invested in higher performing global equities and in this period, equities were doing particularly well. The low-risk fund invests in the bond market concentrating on a more cautious risk. Over time investments like these can be part of a balanced investment, which can contain numerous, sometimes hundreds of individual assets.

No specific investment or asset class will do well all the time and although investment managers have an eye on their markets, they don’t get it right all the time.

Graph 3

These are the same two funds, but now showing the full 12 months.

Each is focussed heavily on their particular remit, so to diversify your risk you could choose to have 50% in each as the next example shows.

Graph 4

Now we have combind the two funds into one, shown as the red line. Each fund is shown separately in grey. They are split 50/50 to achieve an average between the two. Combining them results in a more even balanced risk.

So what do we make of all this?

This shows how risk reduces over time, flattening out the highs and lows.
It also shows the benefit of spreading your investments across a range of different assets.

You should not invest in any risk-based investment for such short periods, even the low-risk fund can suffer a setback in the short term. The longer the time period, the less extreme the risk.

To make this a more complete solution we would add more asset classes to increase diversification, further reducing longer term risk. You might then have a multi-asset managed fund. This same mix of assets can create a lower risk investment, by adjusting the percentages of higher risk asset down and the lower risk assets up. And vice-versa to increase the risk.

OEICS and Unit Trust funds are used in the above examples, the same can be achieved by using ETFs (Exchange Traded Funds) and other types of investments.

Gain some personal experience

The greater your understanding of investing money the more comfortable you will become. If you don’t yet appreciate the complexities of investments, then until you do, you should not take it upon yourself to invest serious amounts of money.

The value of an investment can rise and fall daily and by higher and lower amounts depending on the volatility you are prepared to accept. Understanding this is the key to understanding risk.

Take small steps, start with a small amount, perhaps try an investment ISA. Read about the funds and pick one that appeals to you that’s managed and not focussed on one type of investment, with a moderate risk. Don’t be impatient, investment needs time. If it falls in value don’t panic or sell, you will lose money, just watch and wait. If it rises quickly, watch and wait, you can be sure it will go down as well. Always beware of what you don’t know.

You only know your investment’s true value on the day you sell.
Otherwise you’re just looking through a window in time.

Take advice

For serious and important amounts of money, however skilled you might be, there will be a benefit in using an experienced investment adviser. They will help you make informed decisions leading to better growth for the risk you take.

More about Risk

Think about increasing risk if:

You have TIME.
You don’t need income.
The money is extra to your needs.
You don’t need the money at a particular point in time.
You don’t mind seeing a big loss sometimes.

Think about reducing risk if:

You don’t have TIME.
You need to take an income.
The money important to your needs.
You need the money at a particular point in time.
You would lose sleep if it lost big time.

Time and Volatility

Time has a big part to play, it flattens out the short-term effects of more volatile investments. Investors with time to spare are more comfortable investing in higher risk longer term investments with higher potential returns. You will have a different risk tolerance if you need funds to be more readily available. In general, low risk is associated with lower potential returns and high risk with higher potential returns.

And just to be awkward, low risk can give better returns in certain market conditions and shorter time periods.

Five years

This is how long you should expect to invest money for before expecting suitainable returns. Shorter periods depend on your lucky timing of the markets and choice of investment. Historically, a five-year period smooths out volatility and most examples of well managed portfolios looking back over 50 years, show a gain over every 5 year period.

Make sure your time frame is long enough if you’re going to need the money for a specific purpose.

Diversification

If you buy a share in a company making sunglasses and another share in a company making umbrellas, you have diversified the risk, one goes up when the other one goes down. The more shares you buy in companies with different perspectives, the more you diversify your risk.

To diversify further, buy into bonds and other assets classes.

If you follow this to its logical conclusion there comes a point when you have an average across every type global asset and index. You will end up with a global multi-index-tracking portfolio.

This is Passive investing where your money tracks the average across market indices. If you don’t want average the alternative is Active investing, when the manager is actively engaged in beating the average.

Retirement Income Risk

A secure income is achieved with careful planning

If you are cautious with the income you take out each year, have annual planning reviews and re-run Income Planner, there is little chance of running out of money.

One of the highest risks during income withdrawal is a sudden fall in the markets. For example, in 2007/8 and 2020 your fund might have lost 5% or 35% depending on how high your risk was. It can take time to claw back your capital and it’s prudent to stop or reduce your income in these times. If you were in a higher risk portfolio then you can argue that you will recover faster, and that in the past you have benefited from rising markets, so can afford to lose some. Alternatively, most people become more cautious when income is at risk, but it really depends on how much you kept in your set-aside to fall back on.

Growth rates
There are news articles and websites using unrealistic growth projections for retirement income withdrawal. Too much optimism particularly at the outset can lead to a forced income reduction in the future. Careful planning means an increasing income and more freedom of choice.

Allocating Risk

These is one approach to the levels of risk you might consider. Your choice all depending on what the money is for, how important it is and how long you expect it to be invested.

No Risk

State pension, fixed, guaranteed, indexed linked incomes.

Low Risk

Other secure incomes, deposits and money needed at a particular time.

Cautious Risk

Investments where fixed incomes do not cover basic needs.

Low Medium Risk

Investments where fixed incomes do cover basic needs.

High Medium Risk

Investments for extras and unexpected costs, longer term.

Higher Risk

Investments not needed for any particular purpose, long term.