The risk of not understanding risk
Estimated Time To Read: 4 minute(s) 24 seconds
We often come across the word “risk” in our work. Sometimes a client will use it to describe their personality and preferences as they relate to investments (“I don’t want to take any risks when I invest”). The word is also often used by people in the industry. Fund managers, for example, assign a risk rating to their portfolios or may describe them as being low, medium or high risk.
Unfortunately, the typical use of the word “risk” in the investment industry focuses the mind of many investors on only one of several risks that investors should consider. Secondly, it conflates the concept of risk with investment volatility. Volatility being the movement of investment values up and down. Risk and volatility are often intertwined, but they are not the same thing. You could ask the question whether volatility is even a risk for someone who is accumulating capital (the short answer is “no”, but we could spend another whole article on that topic).
The consequence of that? At best, unnecessary stress and worry, and who needs that? (Especially with the last two years we’ve been through!) At worst, not being able to live the life you hope for when it could have been entirely possible to attain. (Had you only been less concerned about one type of risk and more informed and concerned about another).
So how should we define risk in the context of investing and financial planning?
One article we came across described risk as the possibility that you will need money, but you don’t have it [or enough of it] when you need it. We like that definition because it encompasses a few different types of risk, or reasons why you wouldn’t have your money when you need it. Another author described risk as the uncertainty of investment outcomes, with different factors causing that uncertainty. The wider the investment’s range of possible outcomes, the greater its perceived risk.
What then are the different types of investment risk? Said differently, what are the different events/factors that can impact on whether you will have enough money (or access to your money) when you need it? More importantly, to which ones should you pay attention and be most concerned about? And how can we mitigate against those particular risks?
The list below is not comprehensive, but it will give you a taste of how broad this term actually is:
- Liquidity risk or how quickly and easily you can sell an investment. Physical properties and unlisted (private) shares carry this risk. They have a value, but it takes time to sell them. You also can’t see how their value changes over time because they aren’t listed on an exchange, such as the JSE. A property has value, but you can’t take a brick out of your wall and use it to pay for groceries or medical aid.
- Political risk – how government policies can impact on an investment’s business or financials. Or, one that South Africans are often very mindful of, government’s ability to dictate what you may or may not invest in and in what currency.
- Inflation risk –if you lived through the 1970s and 1980s in South Africa, you probably have an idea of what that means at its extreme. If you didn’t, think about the amount of money the tooth mouse left you as a child, compared to the amount children today expect the poor rodent to produce.
- Currency risk – also well known to most South Africans. This is particularly a factor if your investments or income are in one currency, but your liabilities and expenses are in another. Think of receiving a South African pension, and then choosing to follow your children and their families to Australia or Canada.
- Temporary loss of capital or what is more commonly referred to as volatility – the value of your investment doesn’t move in a straight line. It goes up. It goes down. It goes up again. Think of the last 18 months…… At the time, it can be very disconcerting, and it may feel like Armageddon, but it looks like a little blip on the graph of longer-term share market returns. The risk here is that you need to spend the money while the investment value is down and you don’t have the luxury of time to wait for the temporary decline to reverse.
- Sequence of return risk – this is where volatility becomes a risk for someone who is drawing down on their capital. Simply put, it is the risk that market declines in the early years of retirement, paired with ongoing withdrawals, could significantly reduce the longevity of a portfolio. If the volatility occurs later on in retirement, the outcome isn’t likely to be nearly as bad.
And then of course, there is:
- Risk of permanent capital loss. What could cause that? Here the example of the daughter who replaced her mother’s mattress comes to mind. The old mattress was thrown on a rubbish dump, never to be seen again. Unbeknownst to the generous and caring daughter, the mother’s mattress was stuffed full of wads of cash, that were also never seen again. Or the people whose house was robbed, and safe contents, including several Kruger Rands, were never seen again. Investing in a start up business could lead to similar ends.
These are just a few examples. Some can be mitigated against, others we can’t do much about.
In some cases, mitigating against a particular type of risk can increase the probability of another type of risk. For example, inflation is pretty much a certainty over the longer term. Historically, the most effective way to ensure your investments beat inflation is to invest a large part in growth assets like the share market. However, the share market is also more volatile in the short term. So, by reducing the risk that inflation poses, you increase the risk of temporary capital loss. Which risk is more of a “danger” and should be more actively mitigated depends on you, your circumstances and your financial plan. With life expectancies getting longer, we think you should probably be more concerned about inflation.
We attend an annual conference, Humans Under Management, that was started by Andy Hart, a UK based advisor. He gave an interesting perspective on informed vs uninformed risk.
Andy places different types of investments onto a risk scale. Those investments rated closer to 1 are seen by most people as being less risky, or conservative. In contrast, investments on the other side of the scale are seen to be riskier. He calls this scale the “uninformed risk scale”.
Andy advocates for a more “informed risk scale”. In this second scale he has focused on three types of risk – temporary capital loss (volatility), inflation and permanent loss of capital. For investors accumulating capital, volatility risk is less of a concern, the permanent loss of capital is most concerning, and inflation sits in the middle. He has also ranked different investments on this scale, noting which investments are likely to experience which of the three types (or flavours) of risk.
You can find a link to a podcast he posted on the topic on his website, mavenadviser.com
In our podcast series we share more about the values we believe Veritas offers its clients, one of them being education. Our hope is that we can expand your understanding of risk, so that you can make more informed decisions. On balance, that should give you a better chance to live a life that encompasses everything to which you aspire and brings you joy and satisfaction.