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By: Tim Bennett
10.01.2020
10.01.2020
To successfully manage risk, investors need to first understand it and then follow some key principles says Tim in his first video of the New Year.
Three things investors should remember about risk in 2020
After a decade-long bull run, stock markets could deliver shocks at any time. However, that’s no reason to fear investing as we head into a New Year provided you have considered how you are positioned to deal with short-term volatility.
In a nutshell
Categories of risk
The first thing to always think about when weighing up your exposure to risk is what exactly you think you are exposed to. There are three distinct categories that need to be considered;
In summary, price risk is the one we accept for the possibility of making long-term inflation-beating returns. Liquidity risk, on the other hand, is the possibility that we may not be able to sell when we need to and counterparty risk is the (hopefully low) chance that the person on the other side of a trade may go bust and leave us out of pocket. These are all different and need to be weighed up separately – for example, liquidity risk was thrown into the spotlight by the troubles encountered in 2019 by both the Woodford Income Fund and the M&G Commercial Property Fund. Meanwhile counterparty risk may be offset by the existence of a compensation scheme, at least up to a certain amount.
For now though, let’s return to price risk in a bit more detail.
Types of price risk
We all know that equity prices across the spectrum can go down as well as up – this, in pure terms, is market price risk. However, separate to this is the level of personal risk you are prepared to take compared to someone else, or even compared to you at a different stage of life – this is relative risk and is the function of many factors that are personal to you, such as your age, objectives, overall wealth and tolerance for price volatility. Whilst your absolute tolerance for risk may not change much over a lifetime, the level of relative risk that you take should.
The point is that neither of these types of risk should ever be a total barrier to investing and staying invested, even if markets throw out short-term shocks, However, for that to hold true, you do need you understand them both and take the right long-term approach in response.
The risk myth
Like life itself, investing is inherently risky – even doing nothing is not risk-free if it means you might miss out on better options elsewhere (“opportunity cost”). This is as true of decisions about jobs, properties and even holidays as it is about where, when and how you invest.
The perils of taking a seemingly risk-free approach by sitting on the side-lines in cash are clearly illustrated by this chart below. The two lines use Barclays data to show the value of a £25,000 investment in shares compared to the equivalent in cash, adjusted for inflation in both cases. As you can see, cash loses its ability to protect you from inflation over time whereas shares have tended to offer meaningful “purchasing power” increases.
Relative risk?
The key point that is sometimes forgotten about risk is that it is not the same for all of us and it changes as our lives change. For example, if someone invested for you at the age of two, they should have taken a decent amount of investment risk on your behalf in the hope of generating some decent long-term returns. If you are investing the same sum aged 60 on the other hand, you may take a more cautious approach. Equally, two 60-year olds may follow totally different paths once all the relevant factors are considered.
Below I summarise some of these key factors, which in reality need to be considered together.
As we head into 2020, the key takeaway from this is to make sure that you regularly review your overall risk profile in the context of these factors and adjust your positioning in the market accordingly. Also bear in mind that there is no simple answer to the question, “how much risk should I take” albeit there always is an answer once the factors listed above have been properly weighed up.
To find out more
Feel free to email me at [email protected] or contact an Adviser to discuss any of the issues raised here in more detail.
