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17th
Sep
2020

What is risk?

Duncan Glassey

One of the hardest concepts in investing is trying to understand what ‘risk’ really is and deciding how to deal with it. If you asked a fund manager to explain it to you, they would probably provide a lesson on credit, liquidity, and concentration risk (amongst many others) and the volatility of returns, as measured by the annualised standard deviation of returns! Viewing risk through that lens – and assuming you still had the will to live – you would probably come away thinking that cash is ‘low’ risk and equities are ‘high’ risk. Yet when you sit down with a good financial planner, they will be talking to you about a higher level of goals, such as not worrying about money and having the freedom to do what you want, when you want. Risk, when looked at through this lens, should mean anything that makes attaining this goal less certain. In this context, cash may well become the ‘risky’ asset and equities the ‘safe’ asset.

Here’s why: in a great little book titled Deep Risk by William Bernstein – a neurologist, a pilot and financial author – he separates risk into two key types: ‘shallow’ risk, which relates to the non-permanent, although sometimes extended, fall in asset value; and ‘deep’ risk which is the permanent loss of capital, through inflation, deflation, confiscation or destruction. If we avoid assets with uncertain short-term outcomes (diversified equities) in favour of those with more certain outcomes (cash deposits), we risk trading ‘shallow’ risk for ‘deep’ risk. Take a look at the chart below, which illustrates the likely permanent erosion of purchasing power of cash deposits, as a consequence of moderate inflation but low interest rates that we have experienced since the Global Financial Crisis in 2007-9; from November 2007 to July 2020.

Figure 1: Cash can be a highly risky asset – cumulative real returns

Source: Morningstar Direct © All rights reserved UK One-month T-Bills (cash) and Global Equities (MSCI World Index).

Note that the returns are all calculated from the top of the market prior to the stock market fall. Unfortunately, many people with long-term horizons hold far too much cash e.g. around 45% of all money in ISA tax wrappers is in cash ISAs*. This phenomenon is often referred to as ‘reckless conservatism’. In investing, being patient and being brave pays great dividends for the long-term investor.

*FT.com Popularity of ISAs drops to 18-year UK low 31/08/18

Duncan R Glassey
Managing Director – WealthFlow
[email protected]

 

This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed. Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Errors and omissions excepted.

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© 2020 WealthFlow Group Limited
All Rights Reserved | Privacy | Cookies Policy

Registered in Scotland No SC635011. Registered Office: 15 Atholl Crescent, Edinburgh EH3 8HA.

Authorised and regulated by the Financial Conduct Authority
For your protection, unresolved complaints can be referred to the Financial Ombudsman Service