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.

Read the full article: https://www.allangray.co.za/latest-insights/personal-investing/thinking-about-your-view-of-risk/ 

May 29 2018 By Rob Formby - Chief operating officer designate at Allan Gray Financial Planning