What does risk actually mean?

What does risk actually mean?

Inflation, currency fluctuations, rollercoaster stock markets, longevity, the financial strength of financial institutions, and even our own irrational attitudes towards certain asset classes; the world of investment is full of risks that can leave the best laid financial plans in tatters.

While clients can reduce risk, it can never be eliminated. In fact, every decision made involves a risk judgment of some sort. So, risk has to be understood and embraced in all its forms.

People talk about “risk-free” investments, but even investing in gilts carries some element of risk. Invest in gilts or cash on deposit at the building society and your clients are exposing themselves to one of the least understood yet most significant risks to investors – so-called “reckless conservatism”.

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Gilts and cash on deposit are widely considered the safest way to invest. But if clients invest in either of them for a long period, they are virtually guaranteeing missing out on superior returns elsewhere. Barclays has been comparing the returns of equities, gilts and cash since the 19th century. Its annual Equity Gilt Study shows that since 1899 equities have achieved average annual returns of 5 per cent, compared with just 0.8 per cent for cash.

Some risks get bigger over longer time periods, while others get smaller. For example, inflation is a particular risk for people who buy annuities paying a level income for life, rather than an inflation-linked income that involves taking a lower starting income.

If inflation sticks at its historic level of around 2 per cent, goods that would have cost £100 a week when the annuitant retired at 60 will be costing £148 a week by the time they are 80, and £181 by age 90. That inflation-fuelled erosion of purchasing power is bad enough, but if inflation increases to an average of 3 per cent, that £100 basket of goods will cost £181 after 20 years and £242 after 30 years.

While risk increases with time in certain situations, it decreases in others. Returning to the Barclays study, investments in equities held for a two-year period have beaten cash 68 per cent of the time, which, put another way, means equity investors have lost out around a third of the time.

But, stretch the investment horizon to five years and the chance of equities beating cash increases to 75 per cent. Over an 18-year period, equities have beaten cash 99 per cent of the time, and over a 23-year period shares have never lost money.

The rate at which investors invest into or withdraw money from the market will also impact the level of risk they face – so-called ‘sequencing risk’. By making a big investment into the stock market on a single day, they run the risk that they are buying at the top of the market. If monthly contributions are made into a pension over several decades, as many units are being bought during the troughs as well as the peaks, so the overall risk is reduced – a concept known as ‘pound cost averaging’.

But as soon as investors get to the time in life when they are withdrawing from the pot rather than paying into it, the risk challenges change again. Rather than pound cost averaging, there is the threat of ‘pound cost ravaging’ – where a combination of steep falls in the stock market combined with withdrawals mean a portfolio can be eroded very quickly.