The Risk Gap

We are always told that all investments carry risk and that any asset can go down in value as well as up. We know that different people have different attitudes to risk and these will always factor into a personal portfolio, but should it?

Think back to the most risky thing you have ever done. Did it pay off? Was it fun? Would you do it again? Now think of how your friends and family members might answer the same questions. How do you see your own attitude to risk relative to others around you?

When it comes to investment, risk is not entirely subjective. One curious thing about investment risk is that it can mean something completely different for the same investor if the target and timescale is different. Here is a brief illustration of what that means in real terms:

Investor 1 has an objective with a fixed value and a short timescale (for example, a deposit for a house 6 months from now). Clearly, a volatile investment would not be suitable here. If the asset drops by 10% during the next few months, the investor has very little chance of making that back in time. Inflation is unlikely to be a serious issue during that period so a predictable, safe, fixed-interest asset could be best.

Investor 2 has a longer-term objective with aspirational value (for example, building up a fund for a child or grandchild). In this case, inflation could have a significant impact over time and any drop in the asset value early on will have very little effect on the end result due to the time in the market. As long as there is no need to dip into the investment early, it may well be sensible to trade off the volatility to chase higher returns in the early stages.

Now here’s the problem: If you always drive below the speed limit, don’t gamble, eat healthy food, look both ways twice before crossing an empty road and wear factor 50 sunscreen at night, you might consider risk appetite to be very low, but that shouldn’t matter. The investment should be more focused on the target than the investor.

This issue has led to what is widely appreciated today as a gap between the investment returns generated by different groups of people. There are certain demographic trends that can be observed for risk appetite. Your age, level of education, national or social identity, gender and any number of other factors could have a strong bearing on your appetite for risk in general. If this is reflected in your portfolio then you could actually be increasing the risk of not achieving your financial goals by trying to reduce the risk of losing money. Ask yourself which is more important – the short-term unpredictability or the long-term loss?

The most commonly cited risk gap is the one that stems from gender attitudes. It is well documented that women, in general, take fewer risks than men. This may well contribute to a longer and healthier life on average, but doesn’t always help with financial goals over the long term. By shunning high-risk/high-return assets in favour of more stable, ‘low-risk’ assets or not investing at all, many risk-avoiders are limiting what their money can achieve. Interestingly, recent studies have shown that although far fewer women than men will choose to invest at all, those who do tend to generate much higher returns over time than their male counterparts. This could be because those women who do invest tend to be more adventurous or more engaged (or both) with their portfolio than the average male investor.

There is a strong argument for ‘blind profiling’ of an investment portfolio based entirely on the goal or objective of the investment, rather than the personal whims and preferences of the investor. Emotion and personal qualms are often devastating to a financial plan as they take the emphasis away from the target and focus only on the short or immediate term. However, as financial professionals, it is our responsibility to assess the suitability of any investment for a particular client, and personal feelings are important when it comes to the comfort that an investor feels with their finances.

As far as your own investments are concerned, try to be objective and determine whether the risk profile of your assets reflects who you are or what your money is for. Good, professional advice is critical for when you need to take a step back and ascertain if your money is being held back or threatened by your own views and attitudes. Speak with your financial advisor about whether your risk profile is suitable for where you are right now and, more importantly, for where you want to be in the future. Understand that risk requirements, just like attitudes, can change over time and should be adjusted accordingly.

Finally, focus on the goal in whatever you do and make sure that your plans are built around the end result, not just the immediate impact.