Risk is a word often confused between advisors and their clients. All too frequently an advisor is saying the R word and meaning short term volatility and the investor is hearing “chances of losing my shirt”.
Let’s be very clear about this and define what we mean when we use the R word.
The chance of losing my shirt is called permanent loss. The money is gone and is never coming back. Often new investors describe themselves as “conservative investors”.
”Why” I ask?
Answer: Because I wouldn’t want to lose any money permanently.
Well the good news is that everybody is a conservative investor. I have never had an investor give me permission to lose 20% of their capital !!!
In adviser speak ‘conservative’ is used to describe someone who doesn’t want a lot of variation (“uppy downy”) in short term performance (and who accepts the lowest returns as a trade off). So you can see where and how the confusion sets in.
Both types of risk are reduced by two different factors – Chance of permanent loss by diversification or spread of individual investments. Volatility (“uppy downy”) is by the asset allocation or recipe of investment types. They are not the same thing.
Diversification or the spread of individual investments is the only way that you can reduce the chances of permanent loss. Unfortunately investors and advisors pay lip service to real diversification and focus on other things that don't reduce the chance of permanent loss. Mistakenly, human beings confuse the sense of familiarity of investments they have heard of and advisors with brand names they know, with a reduction in the chances of permanent loss. Also they imagine that concentrating your mental efforts on a few investments and really thinking long and carefully about them (or hiring someone else to do so) will reduce possible harm. It doesn't.
The only way to reduce your chances of permanent loss is to focus not on investing wisely but rather in investing widely.
Our investment portfolio contains 8,700 individual publicly listed companies and fixed interest investment.
The result of this diversification is that your chances of suffering permanent loss is, virtually zero (as a scientist I just can’t bring myself to be absolute).
My analogy is a farming one: If your herd consists of 10 cows then you watch the health of your cows (otherwise you will suffer permanent loss). If your herd is 8,700 cows then individual health doesn’t wake you up in the middle of the night. What you think about is the milking characteristics of the herd.
All our portfolios have the same chance of suffering permanent loss because all portfolios have the same list of 8,700 investments. The difference between portfolios is the ratio or recipe of investment types.
When we talk to clients about their portfolio choice we are asking clients to define their attitude to the uppy downiness of the portfolio. More “uppy downy” doesn’t indicate a greater chance of permanent loss (if you disagree with this you need to give me a call).
What we want to know is how emotional you will be in the light of inevitable downward variations in return (have a year when your portfolio goes backwards - to put it more plainly).
This is really an unsophisticated thumb screw test . It’s rather like visiting you in hospital before your appendix operation and asking you how much pain you would like before you are cured. The answer is not surprisingly "as little as possible so long as I can be cured at the end of it".
So we can do better then this. Our focus on capital adequacy modelling before we talk anything about specific investments, delivers us a bridge to help us through your portfolio choice.
First we demonstrate what "uppy downines" you have to go through to reach your long term financial goals. We then describe to you what that amount of volatility will look and feel like and then you will know if this is an acceptable solution. If it’s not, then we can show you the compromises you will have to make in your financial goals.
So setting the volatility of the portfolio is all about the long term performance that you need to reach your financial goals. Then short term we have mentor your investor behavour so you reach the long term!