Why traditional approaches to risk need a rethink

Today’s markets pose a conundrum for anyone with money to invest. The combination of rising inflation and low interest rates make holding cash unappealing. But expensive stock and bond markets mean investing is a daunting prospect.  

It can be all too easy to fall back on the wealth management industry’s traditional response of a medium-risk approach. Formally, this may well be justified through the use of a risk-profiling questionnaire. People will naturally tend to opt for what they perceive to be a safe and sensible option when something as important as their family’s wealth is at stake.

This increasingly looks like an overly-simplistic and outdated approach. In reality, people can and should take very different levels of risk with money they need in the immediate future and funds they may not need for many years, if at all in their lifetime.

Good advice should focus on helping clients understand how much risk they should be taking with different parts of their asset base. Taking too little risk – where you can afford to take more - can be almost as bad as taking too much. This is particularly true as we enter a period of higher inflation and you need to be more proactive in protecting the real value of your capital.

As the chart below shows, even a small difference in return can make a very big difference over the long term. Based on a £1m investment, foregoing just one percentage point of annualised return could mean missing out on over £500,000 after 20 years.

The importance of setting the right risk and return objectives

Theoretical growth of a £1 million investment at different rates of return

Behavioural finance tells us that “mental accounting” – or allocating money to different pots – is an unhelpful bias. The classic example is the case of savers holding onto low-interest deposits, rather than paying off expensive credit card debt. Economically, this makes little sense. There are many other cases where it can lead to poor outcomes. In the world of stock picking, the same behavioural bias can lead to a reluctance to sell shares in a company that is not living up to expectations.

However, one form of mental accounting can actually be a very useful tool when it comes to helping you to understand how much risk to take, and with what parts of your asset base.

We encourage clients to group their financial requirements and goals into different time horizons - and organise assets into “pots” that correspond to each time horizon. Pension funds and other institutional investors adopt a similar approach when they match liabilities with assets of a comparable time horizon.  

Typically, we advise clients to think of dividing their assets into three. In practice, each pot is likely to include a number of different accounts and portfolios. They will probably also incorporate pensions and other tax-efficient investment structures, such as offshore bonds and potentially trusts.

The first pot can be thought of as a cash account, which takes minimal investment risk and is used to fund ongoing living expenses and near-term spending plans. The second holds capital that is invested for the medium to long term. Depending on whether or not you are still working, it can be used to replenish the cash account, ensuring your investments continue to cover your living expenses. The third holds assets that you are not planning on accessing for a great many years. It could be earmarked for larger, future outgoings, such as helping your children buy their first property. Alternatively, you may not plan on using it at all in your lifetime and think of it as your legacy assets.

Building up your pots

We start by helping you to work out your annual expenditure and generally advise clients to hold around three times this amount in the first pot. This is based on the fact that average economic contractions last up to 18 months, according to long-term data from the US National Bureau of Economic Research.

Knowing you can draw on funds for a period of time that is twice the length of the average recession should provide significant comfort. It gives you certainty that you will be able to cover your expenses at a time when other income may be reduced – and, importantly, without having to sell assets at a time when markets may be depressed. This should help you feel more confident taking on investment risk elsewhere.

Working out how large the second pot should be and its appropriate level of risk  will depend on whether or not you are still working and on your outgoings. Investors who have another source of income, through employment or business ownership, may be more comfortable taking a higher degree of risk. They can likely cover some or all of their expenses with earnings, allowing this pot of capital to grow faster. However, as you approach retirement or the sale of your business, you may be more comfortable with a slightly lower level of risk.

Clients often think of this second pot as comparable to an investment property: it is a source of regular income that can provide you with additional lifestyle flexibility.

These two pots together should effectively cover your financial requirements for the foreseeable future. This means that the third, comprising funds that you can set aside until later in life, can take the highest level of investment risk. Income should be fully reinvested to benefit from the long-term compounding of returns. This pot may well include an allocation to private equity, which requires you to commit capital over a number of years and may not generate returns for even longer. You may hold assets within structures that allow for them to be passed on efficiently to children, grandchildren or charity.  

“Time in the market, not timing the market”

When investing new money in the market, it is tempting to think that you can improve returns by timing your investments well. This is incredibly hard to do, as even the most experienced investor will readily admit.

Fortunately, there is now significant evidence supporting the old market adage that it is time in the market – and not market timing – that determines long-term returns. Schroders’ researchers recently looked at how investment outcomes dramatically improve over longer time horizons, drawing on almost 150 years of market history. The data suggests that over this period there was a 40% chance of losing money in any given month. However, when looking at a 20-year time horizon, investors lost money in just 0.1% of cases.  

Short-term investors have faced significant risks of losing money, longer-term investors have not

This knowledge doesn’t always make it much easier to cope with a significant drawdown that comes shortly after you have invested. For this reason, many clients prefer to stagger their investments over a number of months. However, it is important to recognise that this can come with an opportunity cost. Over the past 20 years – a period which includes financial crises and a global pandemic – the average monthly total return for the S&P500 has been 0.9%. So while phasing investments can feel like a safer option, in an average year you would have to pay a price for this reassurance.

The framework outlined above is a simplistic model that will need to be adapted to meet your requirements and preferences. However, it is a useful tool for developing a more nuanced understanding of how much risk you should be taking. And that, in turn, makes it more likely that your assets will be able to meet your long-term objectives. The importance of diversification – the principle of not putting all your eggs in one basket – is well understood by investors. But the idea that you should also be thinking of your wealth in different baskets for the purposes of risk profiling is less well appreciated. We think it has an important role to play in helping you to achieve the best long-term outcomes.

Please do get in touch to start a conversation and find out how we can help.

Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.