Affording Risk

We are too frightened of financial risk. Over the long term, not taking risks is riskier than taking them.

What does risk mean to you?

If you go to an adviser for general advice you will (or should) have a discussion about your attitude to risk. You may fill in a questionnaire using terms like "high" and "medium" risk, or "growth" and "value", or enquiring as to your attitude to a 20% drop in your portfolio value. You may feel that neither you nor your advisers are really getting to grips with the issue, but on the other hand you don't know how else to approach it.

Why are we frightened?

We are all too frightened of risk.

We live all the time with the remote, but positive, chance of some catastrophe that will significantly damage our lives: air crash, debilitating illness, loss of a loved one, accident in the home, and on and on.

None of this is pretty, but we live with it and even embrace it. We drive cars, walk in cities, swim in rivers, eat questionable substances from street vendors, allow our teenage children to go out without a police escort and generally tempt the gods of chance every day.

And yet when it comes to the management of our long-term savings we become paralysed with the familiar combination of greed and fear. Mostly fear.

Financial theory says.....

We are taught to believe that there is a risk-free financial option, called cash (or government bonds - much the same). It may not be very exciting, but at least it's safe. Investment theory refers to the return on cash as a "risk-free return".

.......but finance is about money, not value

Money is useless. It's what money can buy that has value. We don't want money. We want a roof over our heads, healthcare, food, the well-being of our families. At the next remove we want a car, foreign holidays and golf-club membership.

And because of inflation we cannot guarantee that a given amount of money can give us those things a long way in the future. Because we do not know what the money will buy.

Why give up value to save money?

So, if nothing is safe, and equities return 6% long term (real terms, meaning adjusted for inflation), and the risk-free rate of return (real) is 2%, how comfortable are you about giving up this premium of 4%? [This is a historical example, not necessarily a guide to the future]

Do you understand the magic of compounding? If a risk-free fund and an equity fund achieve their average returns for a number of years, the following will be true:

• After 10 years, the equity fund will be nearly 50% bigger than the risk-free fund.
• After 20 years, the equity fund will be more than double the size of the risk-free fund.

So, even on a ten-year view you can afford for a third of your equity picks to go bust so long as the rest do only average. Over 20 years you can afford for half of them to go bust. That's a pretty heavy penalty you can afford to carry before you come to regret your "risky" option. (And so long as the 'average' in the future is good enough - don't get carried away here!)

What advice do you need?

No need to be embarrassed that you cannot answer questions on your attitude to risk. Many such questionnaires are meaningless.

A good adviser should probe your life aims, and your attitude to falling short or exceeding them. He can then help you to find an investment strategy with the right risk profile.

This is a long, long way from the traditional approach: "Medium risk, guv? Got just the thing for you, this one's flying off the shelves".