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The business of risk: How much can you afford to put on the line?

23rd June, 2020

The outbreak of Covid-19 has put the spotlight on the concept of risk in a way that has left us with little else to talk about. What are the risk factors? Who is most at risk? How long will the risk remain? This is uncomfortable territory. Both scientific research and human experience show that we are a deeply risk-averse species, a point that has been hammered home by our reaction to the crisis – suddenly the world seems a much riskier place and it is deeply unsettling.

How much risk can we take?

The reaction of the financial markets, meanwhile, has been nothing short of panic. But investing money has always involved taking on a wide range of risk factors – inflation risk, currency risk, timing risk, market risk, liquidity risk, to name a few. This boils down to the old adage that there’s no such thing as a free lunch! If we want to earn higher returns, we must consider if we are able to accept a level of risk.

The problem is that we are not good at assessing risk. Blame it on the hard-wiring in our brains but, when faced with a risky situation, we can’t help allowing emotions to impair our decision-making. One example of this is the fear we have of things that are very unlikely to happen, such as a plane crash. Statistically, the most dangerous part of a flight is the drive to the airport, but this doesn’t make the flight feel any safer than the drive.

So, when it comes to putting our money on the line, we are generally poor judges of how much risk we can take. If you’ve ever filled in a risk assessment form or risk tolerance questionnaire, you may have encountered a question asking how much risk you are comfortable taking on and thought “How should I know?”.

The solution is to put all emotions to one side, which of course is easier said than done (as anyone who’s ever gone for a swim after watching the movie ‘Jaws’ will tell you). It can be done, however, by developing what’s known as ‘risk literacy’ which is simply the capacity to deal with uncertainty in an informed way.

Developing risk literacy

Risk literacy is a framework that helps us make sensible decisions when the outcomes are uncertain – more information, less emotion. For example, if we’re told that our investments may be down 30% of the time or up 70% of the time, which sounds riskier? It amounts to the same message, but the different framing is likely to provoke two different reactions.

But back to the question: how much risk can you afford to take? To answer that, you will first need to look at your needs and goals. Today’s goals are really just our best guess around future expenditures. They help us to better understand when the assets we have today, plus the savings we make in the future, will be spent. This in turn helps us to allocate risk in a more sensible manner. Taking the time to articulate our goals means we are equipped to understand the real impact of market events on what matters most to us personally.

When it comes to short-term objectives, there is little or no risk affordability – that is your ‘rainy-day’ fund, after all – even if taking on too little risk will not allow your money to grow. With long-term goals, it’s different. Here, you really should be taking on more risk in order to grow your pot over time. And if the market declines during that period – a risk that all investors face – you’ll likely have time to make it up. However, conversations around diversification and asset allocation are necessary.

Adopt a long-term, consistent approach

With the outbreak of Covid-19 sending equity markets into turmoil, investors’ risk tolerance has truly been tested. The concept of ‘time in the market’ v ‘timing the market’ emphasises that taking a long-term, consistent, dispassionate approach is generally the best investment approach. But when the going gets tough, our hard-wiring kicks in and we feel the urge to cut our losses and get out.

Getting the right balance of risk and return is not an easy task. It’s virtually impossible to simply set a risk budget and come back to it in 10 years’ time. When deciding your risk budget, you should bear three key points in mind: what amount you could afford to lose in the worst-case scenario; how much growth you are targeting; and the time span you want to get there.

The ‘right’ balance, then, is a strategy that diversifies across equities, alternatives, bonds and cash, and one you can adjust as time passes. Markets will go up and down, goals may change over time, and when your investment horizon shortens you might want to move into lower-risk strategies.

These are perilous times but over the long term, investors are more likely to be up. Remember too that the world has recovered from crisis before and will hopefully do so again. In any case, if you are in the business of investing then taking some risk is essential. To paraphrase an expression, ships that remain in the harbour are safe – but that’s not what ships are built for.

A professional adviser can help explain risk and assess your appetite for risk. Picking up on earlier evaluations, or initiating that conversation today, may prove invaluable in guiding you through these unprecedented waters. The sooner you start, the better the outcome. Why not request a call today?

 

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