We have written about a number of aspects of risk and volatility in financial and investment management recently, including: managing unexpected events; how to act after something goes wrong; the impact of behavioural economics; and the role of your risk profile.
In these posts we have discussed being aligned to your long-term goals, whilst preparing for, managing and adapting to, financial downside risk.
In this article we are looking from the opposite perspective because achieving your investment goals is not about removing all risk. It is about taking the appropriate required risk for an expected long-term return. We have mentioned previously that in the short to medium term, financial risk and potential return are directly correlated. That means a potentially higher return will come with a potentially higher financial risk in the short to medium term. It is also true that the financial risk typically reduces over time. The risk of incurring a loss in one year is higher than the risk of loss over a 10-year period.
A real risk in long-term investment and financial management is not taking the right level of risk. This includes both taking too much risk and not enough risk. What is surprising to many people is that not taking enough risk can be damaging to your long-term goals.
One way that an investor can damage their long-term investments through not taking the right level of risk, is by investing too heavily in cash. In the EU the current European Central Bank rate is -0.5%. Negative! Negative interest rates mean cash deposits incur a charge for using an account, rather than receiving interest. You pay to have your money there.
It has been recently reported that UBS, the world’s largest wealth manager, will introduce a penalty for clients that hold a large portion of their assets in cash accounts as a way to get clients to understand the risks of overexposure to cash, and to defray their costs of managing cash. From next month, clients of UBS will incur an additional annual fee of 0.6% on cash savings of more than €500,000. The penalty rises to 0.75% for those with savings that exceed two million Swiss francs.
This idea that cash can be risky goes against what a lot of people have read and been led to believe. It is true that by holding cash you are preserving what you have and you are removing the exposure risk to financial markets movements. You also have the protection of the EU Deposit guarantee scheme. Subject to a number of conditions and limitations, this protects depositors’ savings should their bank fail.
There are benefits of holding some cash. At Black Swan Capital, we advocate holding a sufficient emergency reserve in cash.
The danger is holding too much cash. The risk is a combination of the negative cash interest rates- you are losing money by holding cash- and the eroding impact of inflation.
Inflation is officially running between 1.5% and 2% in the EU. All other things aside, if you are investing in cash, at zero interest, you are going backwards by the rate of inflation every year and you are getting further away from the goals you are seeking to achieve. If you invested USD$100,000 in cash in 1994, between then and 2019, inflation will have reduced the purchasing power of your cash in the bank by 50% over the 25 years. It has been halved! To have the same purchasing power, meaning to be able to buy today what you could buy then with the $100,000, you would need $200,000 in today’s money.
When you factor in your long-term goals and you realise you need to achieve more than the rate of inflation over a 10- or 20-year period, it becomes clearer how dangerous it can be to your goals to leave too much sitting in cash.
So how much risk should you take?
There is no absolute answer; it is what is right for you. We always start with your goals, with what you want to achieve. We then consider where you are at, the amount and type of investing you have done in your past, and your risk profile. Then we work with you to create a portfolio of investments that will help you to achieve those goals, taking on the appropriate levels of exposure to financial market risk and in consideration of the market dynamics, but not more or less risk than is required.