Risky Business

FINANCIAL PLANNERS – Investment Risk isn’t a thing. 

That’s probably a controversial statement, but it shouldn’t be. 

We hear a lot about so-called ‘Investment Risk’, especially from our esteemed colleagues at the regulator and their army of compliance foot soldiers, but it isn’t the correct language, and it certainly isn’t helpful. 

Let’s break it down. 

When we talk about ‘Risk’ in relation to investments without using a precursor word (e.g. inflationary, currency, liquidity) it’s normally because what we really mean is Capital Risk, i.e. the risk of capital loss. 

So ‘Investment Risk’ normally means ‘Risk of Capital Loss’. 

And as a general guide, we associate higher equity content funds and portfolios with higher ‘Risk’. 

Which again is wrong. 

What we really mean is that the higher the equity content (as opposed to bonds, gilts, and other yield producing assets), the greater the volatility. 

Volatility and risk are two very different things. While one may lead to the other, especially when combined with other factors, they are distinct concepts on their own. 

Volatility is an investment’s propensity for short term fluctuations in value. 

That is not risk. 

If the weather forecast tells you there are likely to be frequent rain showers and storms today, does that increase the risk of you getting wet? 

On its own, no. 

If you stay indoors all day you have zero chance of getting wet, no matter how much it rains. 

However, if you step outside every ten minutes to check if it’s raining, you’re more likely to get wet. 

The weather may have been volatile, but it was your behaviour that created the risk of you getting wet. 

You can put it in an equation like so: 

Risk of getting wet = (Propensity for rain * The number of times you go out and look). 

In the same way, investment volatility on its own does not cause capital loss.  

The human behaviour of cashing in an investment during a downturn is what causes the loss. 

No human behaviour = no loss.  

Irrespective of what the volatility of the investment is. 

If you put someone in a high volatility, 100% equity portfolio, but didn’t tell them and left it for 30 years, what would the risk of capital loss be? 

History would tell us zero. 

Because they wouldn’t look. 

Therefore, they wouldn’t panic. 

Therefore, they wouldn’t cash it in. 

Therefore, there would be no loss as historically stock market returns over the long term have always been positive. 

So, through simplification we can say that if we remove the human behaviour from the equation, we remove the risk and are just left with volatility. 

So why do we use the phrase ‘Investment Risk’ rather than ‘Investment Volatility’? 

To be blunt, it’s because as investors, we like to outsource the responsibility for the risk to others. 

It’s not attractive to be told you are partly responsible for the outcome of your investment and need to do some of the work. 

That’s why diet plans claiming you can eat cake without going to the gym are more popular than those that emphasise healthy eating and exercise. 

The fund management industry, like the diet industry know this and prefers to peddle the notion that some of its funds come as ‘Low Risk’ (all cake, no exercise).  

And the regulator, who should know better, is terrified of being seen to propagate the idea that investors should bear some responsibility for their actions and how they impact the returns. 

But we’re not the regulator, and we’re not clients.  

We’re Financial Planners and we know better. 

So, stop calling it ‘Investment Risk’ and start calling it ‘Investment Volatility’. 

Change the language, change the thought, change the behaviour. 

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