One of my favourite TV programmes is Only Fools and Horses. The immortal words “this time next year, Rodders, we’ll be millionaires!”, will forever be stuck in my head!
In almost every episode Del had another money-making scheme; each time they never seemed to come to fruition. Ironically after all those years of scheming, the one thing that made them rich had been sitting in their garage! Six years later the collapse of the Central American stock market sees them losing all their money.
For most of us, this is just a piece of harmless fiction; but there are some lessons we can take from it. In general it is very easy to get confused between risk and volatility, and the interaction between the two. In this blog I want to explore what this difference is, and why the focus is usually on the wrong measure.
Simply put, risk (when talking about money) is the permanent loss of capital. Del and Rodney were constantly taking risk to achieve their goal; the problem was that even when they achieved it, they wanted to take even more risk and lost everything!
In the real world we may not all take the same levels of risk, but we are perhaps prepared to do similar things on a smaller scale. The lottery has two main draws each week; the chance of winning the jackpot is something staggering like 1 in 40 million! The Euro millions is 1 in 140 million.
If you assume someone does all three draws each year, although they might win small amounts, they are effectively prepared to lose £338 a year. It doesn’t sound much but over a 40-year period for example that equates to around £40,000 (with growth of 5% p.a.).
Risk is a permanent loss of capital whether it is as small as “investing” in the lottery, or as extreme as putting everything we own into a potential business venture.
The measure from the regulatory body often focuses on risk. When we ask clients about risk, we must ask the question about permanent loss of capital. The answers vary but on average this tends to be a figure around 15%. But this figure shouldn’t be confused with volatility.
If we invest in the stock market and look at the price of a share or basket of shares each day, then we know these will move second by second during a trading day. The movement in any direction can be driven by many factors but sentiment plays a major role.
For our clients we use a portfolio of funds (these funds individually will invest in different assets which may include shares of companies).
If we consider the risk – the first question is can that fund lose all a client’s money? The answer is more than likely no. The second question is, can the investments fall in value at any point in time? The answer to this is yes.
It seems a small difference, but this is where risk and volatility differ because the second question is specifically about volatility. We ask clients how they would feel if investments dropped in value over a 12-month period. We are all sensitive to investments falling; if we invest in a more adventurous portfolio then we must accept that when markets go down, it is likely to go down more than a more cautious portfolio. We ask this question as a way of ensuring the client understands that investments will move and finding a level where the investor feels comfortable.
Taking this a step further a few years ago when I had back problems, the physio constantly reminded me to not look at how I felt yesterday but where I had come from. The point being, that day to day I could be in a better or worse state, but compared to where I was at the start, I was in a much better place. Investments are the same; when we invest this is the starting point, where we are day to day is almost irrelevant, the key is the end point.
Risk and volatility
One of the challenges of DIY investing is that there is no emotional backstop and we can get confused with volatility and risk. The markets fall 10%, and our investments do the same. The first thing we do is assume we have lost 10%. But we have only lost 10% if we sell that holding. More than likely if we hold and wait the markets will correct. The problem is that many DIY investors will sell at the bottom.
Risk and volatility are interlinked and one of the key elements of working with clients is understanding their goals. Perhaps best illustrated with two different examples; the first one is if a client needs a fixed sum of money in 12 months’ time. This immediately brings risk into the scenario because there is a finite time horizon and there is no crystal ball to what will happen, markets can rise, or they can fall. If the markets fall, and the client comes to sell then there is a possibility that the investments have gone down and there is a permanent loss of capital.
The second, is slightly different. If a client is taking income from their investments and markets fall then the investments must work harder to make up any potential short term “loss” because they have taken out some of the money. There is effectively a partial loss of capital which over time might correct but the investment has to work harder to replace this.
In both cases there are ways to reduce that risk; for example, with a finite time horizon it can be as simple as taking out the money early (and holding as cash). This protects against any potential fall during this period, ensures the capital is available but if markets rise then the client must accept that this is another risk in that they lose out on that potential uplift in value.
With income the solution is similar; a potential way to avoid negative volatility causing a drag on returns is to set aside 12 or 24 months of income in cash. There is an element of timing so perhaps waiting for a rising market before topping up the cash. On the positive side if the market falls then the fund doesn’t have the income drag and therefore can benefit from any potential uplift. On the downside if markets keeping rising and 24 months of income is sat in cash it can feel that we are missing out. (Although it depends on the proportion still invested/not invested).
To summarise it is very easy to confuse risk with volatility. Risk is a permanent loss of capital whether it is, for example, investing in the lottery, a business venture, a highly geared property or a single share.
Investing money in a collection of funds reduces significantly the potential for a loss of capital. The two important points are when we buy, and sell. Everything else is just noise. The power of financial planning is about understanding how comfortable someone is about the movements in their investments in the short term because that determines how the money is invested. The second crucial element is meeting with clients to understand whether anything has changed in terms of the goals for the money. Anything that brings risk (i.e. there is a need for some of the capital) means that the strategy might need to be adapted to reduce the risk of a permanent loss of capital.
There is too much focus on the meaning of risk when markets fall, as we assume that we have lost money. This is not the case, when markets fall it is uncomfortable but what comes down does normally go back up; this is volatility. We only lose money if we panic and sell, or we haven’t adjusted our plans to reflect a short-term need for capital.
Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.