Understanding risk and its consequences for your savings

The word risk means different things to different folk. Elke Brink explains how it impacts on investments decisions.

“Gambling or tossing a coin in the air constitutes risk as the outcome could be fairly known, even though the result is maybe not known. Being hit by meteorites, abducted by aliens etc. – while tossing a coin, brings a different dimension to the situation as we cannot fully describe the outcomes or the probabilities. The latter concept is referred to as uncertainty.”  This is a quote from the fourth edition of The Economist Investment Strategy, authored by Peter Stanyer and Stephen Satchell.

When it comes to investing, one of the conversations with clients I find most interesting is their fear of risk. This is a concept that is often misunderstood – and something that needs to be clearly defined.

Risk has different meanings for different people and changes depending on the phase of life which we are in. Risk can broadly be defined as the uncertainty that an investment will earn against its expected rate of return. There are a few different risk scenarios – and they all need to be considered when building a portfolio: interest rate risk, currency risk, political risk, market risk (the one we probably speak about most), liquidity risk and reinvestment risk. The list goes on.

Defining risk correctly is extremely important as this will determine your investment strategy.

Yes, markets do move in cycles – and you will experience possibly a few corrections and perhaps even a market crash or two in your lifetime, which is never easy to digest. But equity exposure, as a long-term investment, remains the asset class that has historically been shown to provide for capital growth which outperforms inflation over the long term. This growth will serve you well at retirement stage when you are drawing an income from your investments.

During times of market volatility, many investors turn to cash as a safe-haven, and this is where a different aspect of risk comes in. If you are selling off your equity exposure at a time when markets are in a downturn, your paper losses become real losses. Then, many investors turn to cash as a haven. In April, SA’s consumer price inflation stood at 4.4%. The current yield on cash is around 4%, and if you take some fees into account, inflation is depleting your funds every day. To me, being invested in cash (especially at current interest rates), is as risky as being invested in equities only.

Rather than opting for a low risk portfolio out of fear, it may be worthwhile to spend some time to define what risk means to you and to your investments. Risk profiling is the process of finding the optimal level of risk for you on a per goal basis. There are three aspects that need to be considered when establishing your own risk tolerance.

Risk required is the risk associated with the return required to achieve your goals with the available resources. Risk capacity is the level of financial risk you can afford to take. Risk tolerance is the level of risk you are comfortable with.

Let us be honest, nobody wants to lose money and we find it deeply unsettling when markets fall. But whether you are risk averse or not, sometimes our goals and financial needs will require a certain level of exposure to growth assets. To achieve these goals, such as for example achieving financial independence at retirement stage, it is important to understand and be comfortable with the risks attached to your investment.  If you cannot do so, it might be necessary to reconsider your goals – which is most often not ideal.

Constructing a resilient investment portfolio that mirrors your risk capacity and risk tolerance to your needs and objectives and understanding that one asset class is not a substitute for another, is imperative. Markets and asset classes move in cycles. Diversifying your portfolio will be key as different asset classes will behave differently in your portfolio. Trying to substitute one asset class for another invariably adds a different kind of risk to your portfolio. Yes, risk tolerance needs to be managed for every individual, but to establish our own risk tolerance, you first need to fully understand what risk means.