What really is risk?

One of the hardest concepts in investing is trying to understand what ‘risk’ really is and deciding how to deal with it.

If you asked a fund manager to explain it to you, they would probably provide a lesson on credit, liquidity, and concentration risk (amongst many others) and the volatility of returns, as measured by the annualised standard deviation of returns! Viewing risk through that lens – and assuming you still had the will to live – you would probably come away thinking that cash is ‘low’ risk and equities are ‘high’ risk. Yet when you sit down with a good financial planner, they will be talking to you about a higher level of goals, such as living without worrying about money and having the freedom to do what you want, when you want. Risk, when looked at through this lens, should mean anything that makes attaining this goal less certain. In this context, cash may well become the ‘risky’ asset and equities the ‘safe’ asset.

Here’s why: in a great little book titled Deep Risk by William Bernstein – a neurologist, a pilot and financial author – he separates risk into two key types: ‘shallow’ risk, which relates to the non-permanent, although sometimes extended, fall in asset value; and ‘deep’ risk which is the permanent loss of capital, through inflation, deflation, confiscation or destruction. If we avoid assets with uncertain short-term outcomes (diversified equities) in favour of those with more certain outcomes (cash deposits), we risk trading ‘shallow’ risk for ‘deep’ risk. Take a look at the chart below, which illustrates the likely permanent erosion of purchasing power of cash deposits, as a consequence of moderate inflation but low interest rates that we have experienced since the Global Financial Crisis in 2007-9.

Note that the returns are all calculated from the top of the market prior to the stock market fall. Unfortunately, many people with long-term horizons hold far too much cash e.g. around 45% of all money in ISA tax wrappers is in cash ISAs (FT.com Popularity of ISAs drops to 18-year UK low Aug 31, 2018). This phenomenon is often referred to as ‘reckless conservatism’. In investing, being patient and being brave pays great dividends for the long-term investor.

It’s not a simple, binary, decision of holding cash or a highly diversified portfolio of global equities. Many factors personal to the individual, will come in to play, including, but not limited to, some or all of the following: –

  • The balance between holding sufficient liquid assets for near term spending, plus a contingency fund, and the risk of leaving too much long term return on the table by holding too much cash,
  • The investor’s time horizon; are we planning to a specific timescale or an investor’s lifetime and their desire to leave a meaningful legacy?
  • The return required to ensure the plan does not run out of money,
  • The individual’s tolerance for the uncertainty of investment values and timing of returns

The best decision for individual investors will depend on their personal circumstances, which is why professional advice and a detailed, goal specific, financial plan is key.

Dominic

About the Author

Dom is a qualified and experienced Chartered Financial Planner (CII) and Chartered Wealth Manager CFP (CISI) and a Registered Life Planner (Kinder Institute) with over 30 years experience. His work primarily focuses on retirement income planning, helping clients to maintain financial dignity and independence in retirement. Read more from Dominic...
This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.
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