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Table of contents
Introduction
Objectives and Timescale
Risk Tolerance
How much cash should I keep back?
Covid-19
Conclusion

Introduction

Earlier this year we published an investment bulletin “You make most of your money in a bear market, you just don’t realise it at the time” which discussed how the fall in global equity markets in February and March offered an opportunity to investors.  In response to the crisis, Saunderson House increased equity allocations for all clients.  Our rational for buying equities has been covered in several other notes and webinars, so won’t be repeated here.  Instead, in this note we will look at the question of how we establish what is an appropriate level of risk for each of our clients, and their differing circumstances and attitudes.

Objectives and Timescale

With any client, our initial conversations are always focussed on financial objectives.  For most people their main objective is “financial independence”, which is having sufficient wealth that major life decisions such as whether to retire can be made based on lifestyle and wellbeing rather than decided by a need for further income.  Added to this are often other secondary objectives which will require a lump sum at some stage, such as providing house deposits for children, buying a second home or paying off a mortgage.

These different objectives will all have different timescales (defined as how soon you will need the relevant sum of money), and all need to be factored into any discussions around risk.

The reason timescale and risk are so closely tied together is because of the volatility of higher risk assets (equities and commercial property).  Looking at US market data (nominal, price only, Schiller data) since 1926, investing over 1 year would have made you a profit 69% of the time.  However, in the worst twelve-month period (from June 1931-1932), markets were down over 65%.  For anyone with a short-term need for a lump sum, a loss of this scale could be a huge problem.

The graph below shows a period in which two very significant market crashes took place and highlights how the longer the time frame, the less of an impact these crashes are likely to have:

In this context, if you had invested in 2005, needing your money back in early 2009, you would have suffered a loss of around 30%.  In contrast, if you had invested in 2005, needing your money back in 2020, you would have seen a better return than cash even if you had sold out at the bottom of the Covid-19 crisis.

Finally, it is worth noting that for most people’s main objective, funding their retirement expenditure, this is no longer about having a lump sum on a specific date.  Changes to both pension legislation and working practice mean that funding retirement now looks very different.  Almost all but the most cautious high net worth investors now opt for drawdown rather than annuity purchase, and so fund their expenditure by drawing gradually from their investment portfolios.

For clients of Saunderson House, we consider timescale by placing people in a stage of the investment cycle which reflects their current circumstances.  This is regularly reviewed, and changed when appropriate.

Risk Tolerance

Risk tolerance for our clients is whether we define you as ‘cautious’, ‘balanced’, or ‘adventurous’.  There are three elements which need to be considered for this:

  • How you feel about risk;
  • How much risk you can afford; and
  • How much risk you need to take.

When we refer to how you feel about risk, this is about the psychological impact of market volatility. If you see your portfolio fall dramatically as we have in recent months, do you lose sleep over it, or do you accept that stock market losses are the price of admission for higher long-term returns?  While a diversified portfolio will recover after the market crashes, this only helps you as an individual investor if you are happy to remain invested through the dips rather than selling low.

The second factor which contributes to your personal risk tolerance is how much risk can you afford to take, which we commonly refer to as your capacity for loss.  This is a discussion which requires significant context, as it is not ‘how much of a loss to your portfolio over the next twelve months would feel uncomfortable?’, but rather ‘how much of a loss could your portfolio sustain over the next twelve months without impacting your standard of living?’.

For our clients this is often quite a high percentage.  For those still in the main earning years of your career, any fall in the value of your pension is unlikely to affect your immediate standard of living as you would not be accessing these monies anyway.  A short-term fall in markets would only be a paper loss and we would expect markets to recover.  Even for those in retirement, our clients tend to only draw a small percentage of their portfolio each year, and will almost all have equity in their homes which they could call on in a particularly extreme scenario.  As a result, most of our clients do have significant capacity for loss, even though they may not realise this without a more in-depth discussion.

The third factor to contribute is how much risk do you need to take? This links back to your personal objectives discussed above, and will be different for different people.  For some, a nominal amount of extra risk might be beneficial as the greater long-term returns you would expect from a higher risk portfolio might be the only way to achieve your objectives.  For others, however, they may already have enough money in their portfolio to meet all of their objectives.  In this scenario there needs to be some very careful thought as to whether you will benefit from additional risk (or any risk at all).

Importantly, these three factors will not necessarily align, and so an in-depth discussion with your advisor is always recommended.  Our advisors will be able to help you understand the competing demands of these factors and to come up with the correct solution for you.

How much cash should I keep back?

It is also important to recognise that other factors that impact your wider financial planning may also be changing.  Is your job as secure as it was prior to the Coronavirus? If you are self-employed or your earnings are variable, do you expect to earn less over the next year or two?  For those relying on investment income, unpaid rents and reduced dividends could have a significant impact.  These factors could mean that you need to reconsider what a sensible cash buffer is for you and your family, and may be a reason to hold more cash, even though it means missing out on an investment opportunity.

Covid-19

The recent pandemic will have brought investment risk and objectives sharply into focus for many people.  Inevitably, some people will have seen their objectives change either through changing fortunes in the workplace, or new plans about the balance between work in the office and at home.  We have already had conversations with a number of clients for whom a home outside of London has now taken on far more importance.

The sharp falls in equity markets back in February and March will also have given people a first-hand feel for how they will react to a market crash.  For those who were able to remain invested without too much undue worry, it has helped to reaffirm that they can take the current level of investment risk.  However, for others it may have indicated that the emotive factors play a bigger part than they realised.  For our clients, it has provided a good example of how we manage risk within portfolios, increasing equities while markets were depressed.  Following Warren Buffet’s advice to “be greedy when others are fearful and fearful when others are greedy” is easier to do when a professional is making these decisions for you with some of the emotion taken out.

Conclusion

Timescale and risk tolerance need to be looked at together to give an indication of how much risk you can afford to take in the long term, and consequently whether it is appropriate to buy risk assets now.  Importantly, being a ‘cautious’ investor does not mean that you shouldn’t be buying equities when markets are low.  While it will feel like a high-risk decision at the time, equities are actually less risky after markets have fallen.

With the benefit of hindsight, the circumstances back in March, April and May offered a great opportunity for many investors to buy into equities at a discount, in line with the recommendations of our investment team.  Any decision to change the level of risk within your portfolio needs to be made carefully in the context your wider financial planning, including your risk tolerance and time horizon.

If you have any questions about how this impacts you, please contact us.

About The Author

Olly Cheng
Olly started at Saunderson House in 2008, following the completion of an M.Phil in Social and Economic History from ...
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