Consider the longer-term impact

That is what history has told us. So, I hope that I have established two vital ingredients: compounding and time. How has this played out for investors?

All of today’s discretionary fund managers offer advisers and their clients active investment portfolios that are risk rated; the riskiest is most likely 100 per cent invested in equities, while a mid-range portfolio will be 50 per cent or so invested in equities.

Naturally, it should always be borne in mind that risk and return are inextricably linked and that riskier portfolios are likely to garner higher returns but at the cost of greater volatility. 

Risk and return

What is important for all clients of discretionary fund managers, one hopes, is that they are exposed to the amount of risk that their tolerance permits, but also that they are both beating inflation, that is, over time they are becoming better off and earning a return in excess of cash (risk free rate).

Take a mid-range, medium risk portfolio, for example. The annualised return of this given  portfolio is plus 6.9 per cent a year with three and five-year volatility around 6.5 per cent. 

It should be no surprise (risk and return being linked) that a high risk portfolio from the same stable has done rather better plus 9.8 per cent annualised return but with greater three and five-year volatility of a little over 9.5  per cent. Has taking on risk been worth it? The answer in this case is clearly ‘yes’ as the annualised return from cash has been a paltry plus 1.81 per cent a year and inflation at plus 2.99 per cent a year.

Therefore, an investor that left all his or her money in cash has no risk (below the FSCS £75,000 limit) except that they would have lost purchasing power, that is, getting worse off over the entire period.

In conclusion, “history never repeats itself – it merely rhymes” so there are no guarantees that the future will be the same as the past but it is likely to be similar.

Those prepared to accept ‘equity risk premium’ are likely over the longer term to be rewarded by higher returns from those who are not.

Stephen Watson is director of Beaufort Investment