Personal investing

Thinking about your view of risk

Our primary concern as an investment manager is creating wealth for clients. To do this, we need to balance investment performance for clients with the risk incurred in generating this performance, which is really the risk of losing our clients’ capital. This informs every decision we make and is built into our investment philosophy. Rob Formby explains how what you think about risk effects your investment.

Investors want to avoid loss of capital, but risk can manifest as volatility of performance, sustained underperformance or longevity of capital, and the effects of these are often overlooked. An investor who overestimates the risk of an investment, and is too conservative, may miss out on returns in the long term. We see this with some retirees who invest in the money market fund exclusively, in fear of the volatility of other investments. In the short run, their money is probably safe, but the returns that a money market fund offers may not keep up with inflation over time. In the long run, returns will not be enough to sustain them in retirement. In the reverse, if risk is underestimated, the ups and downs may be too much to bear for an investor and it may force them to withdraw before an investment has had time to give them their required returns, or exit at the worst possible moment, like when press coverage is negative and an investment is underperforming.

A successful investment is when there is a match between the risk you expect or perceive and the actual risk of the fund

We manage a range of unit trusts with different levels of risk: As a rule of thumb, the more equities a fund invests in the more risky it is likely to be. However, our part is only half the equation. The way you think about risk relative to performance and the individual tolerance that you have for this are as important, as they influence the investment choices you make. A successful investment is when there is a match between the risk you expect or perceive and the actual risk of the fund. Calibrating your risk tolerance is a problem of psychology and the most difficult psychology to solve is often your own.

Generational and cultural influences

The way we think about risk is not formed in a vacuum. Past experiences play a big role in the way we perceive it. Overlaying your personal perceptions of risk are generational views of risk. The shared history of a cohort means that the risk perceptions of millennials (generally accepted as people born between 1982 and ~2000) are markedly different from that of their parents’ generation and of their grandparents’ generation.

A US study done by Legg Mason about the views of millennials on investment shows this in practice: 85% described themselves as conservative investors, with a lower portion of their investments in equities compared to that of their parents’ generation, despite the age difference. Millennials experienced the disruption of the global financial crisis up close either directly or through their families. It is no surprise that this left a risk-averse mindset in its wake, especially in the more impressionable generation that experienced it early on in life.

Closer to home it makes more sense to compare born-frees and the generation before them. Someone whose formative years were occupied by a ceaseless state of emergency in the 80s and culminated in the very real threat of civil war in the early 90s would have a different view of risk from someone whose history begins with free elections and strong local returns over the past few decades.

Likewise, wealth and cultural differences play a role. Being raised in a household where investments are discussed gives one a comfort with market risk that someone who learns of these ideas later will take time to acquire. It is easy to overlook how important comfort with markets is in becoming a successful investor. Stokvels are prevalent because many South Africans are more comfortable with the risks associated with trusting our neighbours than the sometimes opaque forces of the market or even the trustworthiness of a savings provider.

Your personal perception of risk

As much as our generational and cultural influences affect our perception of risk, we also all have a personal slant. A successful investment may have made us a bit overconfident or perhaps a negative experience has tainted how we view investments.

Risk perceptions can be quite irrational. Many people are afraid of flying, but are quite comfortable with the statistically riskier activity of driving because they are in control. The perception of control can affect how we personally feel about the riskiness of an activity.

So where does this leave us as investors?

We should put more intentional thought into what “risk” means for us and how this is likely to affect our tolerance levels and investment decisions. You can achieve this by doing the following:

1. Determine how risk could impact you. It is important that you understand what you are trying to avoid – is it loss of capital, it is performance below expectation for an extended period, or is it performance that varies? Often it is less scary than the permanent loss of capital that the term “risk” conjures up.

2. Work out your tolerance levels. Understand at what point you will become uncomfortable and under what conditions this is likely to happen. Remember that
everyone will have different points based on generational, cultural and personal factors.

3. Match the risk tolerance with the profile of the products you want to invest in. Some unit trust fact sheets include a risk spectrum indicator to show the fund’s profile, but generally, the higher the equity exposure the higher the risk.

If you are uncomfortable with any of the above steps it may be worthwhile consulting an independent financial adviser. Having someone test your outlook can give you a more objective view. Alternatively you can use risk profiling tools (which you can find online).

Lastly, a way to correct your perception of risk is to feel a measure of control. Be the driver of your investment and not a passenger. This may mean that you research your investment so that you feel less like a victim of the vagaries of the market. Of course no-one can know what the market will do, but knowing a little bit more may make you feel more comfortable with investing in it.

If this is done well and your risk perception matches that of the investment you choose, it can go a long way in ensuring that you start off on the right foot.

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