Investment and risk
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What is an Investment?
Investments are different to bank deposits
Investments give a variable return. They are for the long-term, usually years or decades. Investing is one of the key strategies to building long-term wealth and financial security.
Money invested can maintain buying power as it can equal or beat inflation.
Deposits give a fixed return. They are for the short-term and 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.
With money in a deposit account you are effectively ‘lending’ it to the bank, they may pay you a fixed or variable interest rate in return.
The bank has full control of how they invest or lend out your money and they keep the profit
The bank takes the risk
When you invest money you by-pass the bank.
You have full control of your money and you keep the profit
You take the risk
About Investment Risk?
Risk is necessary, just don’t over do it
Managing investments is a balance between risk and return
If you left the money in the bank it would fall behind inflation.
The money would lose value
If your money grew by the rate of inflation every year, it would always buy the same as it did when you started.
The money would keep value
If your money grew by more than inflation you would have real growth above inflation.
The money would increase in value
How do you decide?
Think about a increasing risk if:
- You have TIME.
- You don’t need income.
- The money is extra to your needs.
- The money isn’t needed at a particular point in time.
- You don’t mind seeing a big loss sometimes.
Think about a reducing risk if:
- You don’t have TIME.
- You need to take an income.
- The money important to your needs.
- The money is needed 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, time flattens out the short term effects of more volatile investments. Younger investors are more comfortable investing in higher risk longer term investments with higher potential returns. Older investors would have a different risk tolerance since they will 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.
To be get the returns you expect, five years is considered the minimum period to invest for. Shorter time frames 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 going back over 50 years show an acceptable gain over 5 years.
In the short term you may well succeed, but it’s not long enough to even out the peaks and troughs. If you’re going to need the money for a specific purpose, then make sure your timeframe is long enough.
Diversifying the Risk
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.
There’s more about Active and Passive investing in The Cost section.
Annuities v Income Drawdown
A cautionary note
Pension annuities are issued by insurance companies, they are secure and guaranteed. You purchase an annuity in exchange for your pension, saying goodbye to the cash in exchange for a guaranteed income for as long as you live. This can be an increasing of level income and there are many variations. However this is not meant to be a detailed understanding of annuities.
Income drawdown can be the wrong choice, especially if it’s to pay for your basic income needs, so when you use income drawdown it’s important to have some fixed incomes, or access to other investments to fall back on. This is where financial advice can guide you.
Constructing a Balanced Investment
This is to illustrate the spreading of risk across different asset classes, to show how risk can change over the short and long term. These are two unnamed funds chosen because of their diverse investment styles and these are actual figures. One is ‘lower risk 2′ invested in Bonds or Fixed Interest Securities, not to be confused with Investment Bonds. The other is ‘higher risk 7′ invested in Global Equities. Each of these funds contains numerous investments, whilst staying within the specified remit or ‘asset class’ of the fund.
Risk here is measured 1 to 10, 1 being lowest and 10 highest. A medium risk would be 5.
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 it would not be unexpected that you might choose the lower risk fund.
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 risk global equities and in this period equities were doing particularly well. The low risk fund is invested in the bond market concentrating on much lower 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.
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.
Now the two the funds are combined in the red line and each are shown separately in grey, they are split 50/50 to achieve an average between the two. Combining them balances the two risks, resulting in a more balanced risk.
This is a crude example, but it shows how risk reduces over time, you would 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 would then have a multi-asset managed fund. This same mix of assets can be used to 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.
The above examples are based on investment funds – OEICS/Unit Trusts, the same can be achieved by using ETFs (Exchange Traded Funds) and other low cost 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 money without guidance.
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, but something managed and not focussed on one particular type of investment, and not high 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, gain an understanding before you invest a little more. If it rises quickly, don’t think it will continue, watch and wait, you can be sure it will also go down as well. Always beware of what you don’t know.
An investment’s true value is on the day you sell, otherwise you’re just looking through a window in time.
For serious and important amounts of money, however experienced you might be there will be a benefit in using skilled investment adviser. They will help you make informed decisions leading to better growth for the risk you take.
Retirement Income Risk
A secure income can be achieved with careful planning
With a restrained view of growth and income withdrawal and annual plan reviews, 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 the 2007/8 crash 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 in your Savings Pot number 2 to fall back on.
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.