Investment risk can be defined as the probability that an investment’s actual return will differ from its expected return. While most people tend to link investment risk with the sharemarket, as outlined by Grant Samuel Funds Management, there are several risk factors that can impact investors whatever the asset class…even the trusty term deposit.
If you were to take a straw poll of investors and ask the question “what do you most want from your investments?” the likely responses would be:-
‘…not to lose money’
‘…peace of mind’
‘…to get a good return’
Whether an investor is accumulating assets, or is pre-or-post retirement, fear of capital loss can often drive poor decision making. US-based research company Dalbar[1] has been studying investor behaviour since 1994. In its most recent report, it found that in 2014, the average US-based equity managed fund investor underperformed the S&P500 by a wide margin of 8.19%. Over a 20 year investment period, the average investor underperformed the market by 4.66%.
The reason? Fear.
Fear of losing money when the market drops, buying back in when it starts to pick up. Decision making that can result in losing capital.
Most people associate risk with investments in growth assets, such as equities and alternative investments. Few consider money in the bank or conservative investments as risky, although the current low interest rate environment has defensive investments such as fixed income and cash looking increasingly less likely to meet investors’ objectives.
In fact, the recent rate cut by the Bank of England (BOE) not only had interest rates at the lowest in the BOE’s history, the rate cut caused British government bond yields to trade in negative territory, which had a negative impact on UK pension funds. Government bonds are generally considered one of the least risky assets!
1. Sequencing risk
Sequencing risk is the risk that the order and timing of investments and returns are unfavourable. The wrong sequence of returns can have a particularly significant impact on a retirement portfolio.
For example: an investment is made toward the end of the accumulation phase, just before a market correction. If the market falls 30%, it subsequently needs to return 43% just to get back to the same point. A retiree may not have time to recoup such losses.
Volatility in markets and the order in which investment returns occur can make a big difference to the capital base once investors begin to draw on their retirement savings. If investors experience positive investment returns in the first few years of retirement, they will be better placed to ride out market downturns.
2. Longevity risk
Put simply, longevity risk is the risk of outliving your assets. Australian retirees could face a shortfall in their retirement savings as life expectancy continues to increase, thanks to improvements in living conditions, health and medical advances.
People generally retire with a fixed amount of money to fund their retirement; the unknown is, how long they will live and, therefore, how does long their money need to last?
According to the Australian Bureau of Statistics (ABS):
- males aged 65 are expected to live a further 19.4 years
- females aged 65 are expected to live a further 22.4 years.
Many retirees risk outliving their savings if they invest too conservatively, but many fear the impact a sharp downturn in markets could have on their capital. With interest rates continuing to trend downward, ‘money in the bank’ is not the safe option it once was for investors who require income and need to preserve their capital.
3. Equity market risk
The performance warning that accompanies data and charts says it all – past performance is not a reliable indicator of future returns. History demonstrates that although equity markets will experience downturns, the longer-term trend is up. The timing however, may not fit in with each investor’s time horizon; if it doesn’t, a market downturn can expose that investor to both sequencing and longevity risk.
4. Inflation risk
The risk that investments and income lose purchasing power over time as prices increase. Purchasing power is the value of money, expressed in terms of the amount of goods or services that one unit of money can buy. Higher inflation means less purchasing power.
In the current low interest rate environment, investors eschewing equities in favour of the relative ‘safety’ of cash may in fact be creating future problems. Once tax has been paid on the interest earned, will the income beat inflation?
Like investment returns, inflation has a compounding effect over time.
For example, according to the Reserve Bank of Australia’s Inflation Calculator, a basket of goods and services worth $100 in 1990 would have cost $187.42 in 2015 – an increase of 87.4% over the 25 year period.
There is a role for both growth and defensive assets in a diversified portfolio, although neither is immune from risks. There are however, a range of strategies that can be implemented, to help mitigate each of these risks. Such strategies include regular investments to provide dollar cost averaging, and sourcing investments that offer some portfolio hedging strategies or the use of volatility overlays.
[1] Dalbar’s 21st Annual Quantitative Analysis of Investor Behaviour, 2015, Adviser Edition
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