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27th
Mar
2024

Risk means different things to different people

Risk means different things to different people

Trying to explain what ‘investment risk’ is in a short note is a challenge as it means different things to different people.  To a person with little knowledge of investing, putting money into the stock market can feel like a risky thing to do.  After all, they have probably been told, or read, that stock markets are very volatile and are therefore ‘risky’ and not for the faint hearted.  With bank deposits paying a decent return in 2024 compared to recent years, they may be tempted to remain in cash. 

To someone who is an experienced investor and has weathered some tough stock market downturns but has been rewarded with strong overall returns from dividends and share price rises, being invested in the stock market feels less risky than the reckless conservatism of placing bank deposits.

The problem here is one of timeframes and inflation.  In a year’s time, one can be more certain of what your cash will buy you than your stock market investments.  In twenty years’ time the risk is that you do not have enough in your cash pot to support all the lifestyle dreams and choices that you had hoped for. This could be described as ‘goal risk’ and one that all investors should be focused on.  The chances are that over longer time frames, cash becomes the riskier asset as it is less effective at delivering growth in purchasing power than stocks. Using long-term US data (1926-2023), cash has delivered around 0.3% per year above inflation, but that masks the very material losses in purchasing power that it has experienced over this period. US stocks, on the other hand, delivered a little over 7% per year above inflation. In purchasing power terms, over this 98 year period, US$100 grew to US$135 for a holder of cash, whereas for a holder of US stocks this turned into US$85,300[1]

The chart below illustrates the catastrophic losses in purchasing power that cash suffered over this time period.  It took over seven decades for US$100 of purchasing power in 1933 to return to the same level.  That is risk.

Figure 1: Holding cash can seriously damage your wealth (US cash after inflation 1926-2023)

Risk means different things to different people

Since January 2009, cash has lost 25% of its purchasing power, yet this is only half of the 50% fall in value of the 1930s and 1940s.  Alternatively put, US$100 held in cash in August 1989, is still only worth US$100 today, whereas if it had been invested in equities, it would be worth over US$1,000 in purchasing power terms. 

Investing in stocks can be risky from an emotional point of view, as they suffer severe peak-to-trough falls.  For example, US stocks have fallen more than 50% on four occasions since 1929, with the worst fall of almost 80% (after inflation) being the Wall Street Crash that started in 1929 and bottomed out in 1932. It would be hard for most investors to suffer such egregious losses and stay focused on their long-term plan. Yet, those with the emotional and financial capacity to stay invested recouped these losses by the end of 1936.  More recently the ‘dot.com’ crash of the early 2000s took US equity investors nearly 13 years to recover from. 

Even this simple example illustrates how multi-faceted risk is.  Investors need to be aware not only of short-term volatility, but also of goal risk which is materially influenced by inflation risk during the investor’s investment horizon, and the prolonged periods that portfolios can potentially be under water (drawdown risk) once inflation is accounted for.  Helping investors to balance – and where possible mitigate – these risks is an important part of a Financial Planner’s role.

Global diversification to reduce the impact of market specific falls can help, as may incorporating different styles of stocks, such as smaller companies and value stocks and potentially other asset classes such as global commercial property.  Allocations to shorter-dated, high quality bonds can help to dampen short-term volatility and inflation-linked bonds may help to mitigate the risk of inflation to some degree.

Understanding what risk really means to you is an integral part of the financial planning and investment process.  Your Financial Planner can help.

‘Risk surrounds us and envelops us.  Without understanding it, we risk everything and without capitalising on it, we gain nothing.’

Breakwell and Barnett[2]

[1]    Morningstar Direct © All rights reserved IA SBBI data for US T-bills (cash) 1926-2023
[2]    Breakwell, G., Barnett, J., (2007) The psychology of Risk: An Introduction. Cambridge University Press p1.

 

Duncan R Glassey
Founder & Director – WealthFlow
duncan.glassey@wealthflow.com

 

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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© 2024 WealthFlow Group Limited
All Rights Reserved | Privacy | Cookies Policy

Head Office & Consulting Rooms: 10 Charlotte Square, Edinburgh EH2 4DR.

Mail correspondence to our Central Scotland Admin Hub: WealthFlow Group Limited, PO Box 14947, Grangemouth FK3 3AU.

WealthFlow Group Ltd is authorised and regulated by the Financial Conduct Authority.

The guidance/advice contained in this website is subject to the UK regulatory regime and is therefore restricted to consumers based in the UK.

For your protection, unresolved complaints can be referred to the Financial Ombudsman Service.

To contact the Financial Ombudsman Service, please visit www.financial-ombudsman.org.uk.

WealthFlow Group Ltd. Registered in Scotland No SC635011. Registered Office: 10 Charlotte Square, Edinburgh EH2 4DR.