Investing is inherently risky.
When you buy shares in a company (aka. Equity), there's a chance the value could drop significantly, meaning you might lose money.
This risk doesn't just apply to individual companies - it can affect the entire market. For instance, during the 2007–2008 Global Financial Crisis, the US S&P 500 index fell by about 57% from its peak to its lowest point.
However, the other side of the story is that equity markets have historically rewarded those who stay invested for the long term. Over the past 30 years, even including that major drop, the S&P 500 has delivered an average annual return of around 10.7%.
Investing isn’t about avoiding risk entirely. Instead, it’s about understanding the different types of risk, accepting them, and managing them wisely to achieve your financial goals.
The Shortcomings of Volatility as a Measure of Risk
When people talk about investment risk, they often cite volatility, which measures how much an investment’s value goes up and down over time. It’s the most commonly used risk metric.
Regulators and financial institutions like using volatility to measure risk for three main reasons:
- It’s Easy to Quantify: Volatility gives a clear number that can be tracked, reported, and compared.
- It’s Based on Historical Data: With enough past performance data, volatility can be calculated for almost any investment.
- It Simplifies Complexity: For regulators overseeing many types of investments, volatility provides a straightforward, universal benchmark.
However, volatility has significant limitations as a measure of risk.
- Volatility Does Not Equal Loss: Volatility tells you how much an investment’s price fluctuates, but that doesn’t necessarily mean you’ll lose money permanently. For example, shares are more volatile than bonds, yet they’ve historically provided much higher returns over time. If you avoid investments simply because they’re volatile, you might miss out on opportunities for superior long-term gains.
- It Ignores Your Personal Goals: Volatility doesn’t consider your specific needs, like how soon you’ll need your money or your comfort with short-term price fluctuations. A young investor saving for retirement decades away can afford to take on more volatility to achieve growth. In contrast, someone close to retirement who depends on their investments for income may need a steadier approach.
- It Overlooks Other Risks: Focusing only on volatility means ignoring other crucial risks, like inflation (the loss of purchasing power), longevity (outliving your money), and changes in regulations. These risks are equally important but harder to measure with a single number.
- It Can Be Misleading During Market Crises: Volatility often spikes during market downturns, making investments seem riskier just when they may offer the best opportunities to buy. This can cause investors to sell in panic, locking in losses and missing out on recoveries when markets rebound. On the other hand, after a long period of rising markets, investments might look safer than they really are, even though a market correction could be just around the corner.
Volatility: a Friend not Foe
As famed investor Howard Marks, co-founder of Oaktree Capital Management, explains, volatility isn’t the enemy - it’s a natural part of investing.
While it may feel unnerving in the short term, volatility creates opportunities to buy quality assets at lower prices during market dips. For disciplined investors, this is a gateway to achieving long-term growth.
Other Forms of Risk
Focussing solely on volatility can leave a blindspot for the other important risks in investing.
These risks can have a significant impact on your financial future, but there are strategies to manage them effectively.
Behavioural Risk - The Threat Within
Behavioural risk comes from decisions driven by emotions like fear and greed. For example, investors often panic and sell when markets drop, locking in losses, or buy during market booms, paying inflated prices. This "buy high, sell low" behaviour can hurt long-term returns.
To combat this, it’s crucial to create a clear investment plan and stick to it, especially during turbulent times.
Inflation Risk - The Silent Killer
Inflation risk refers to the gradual loss of your money’s purchasing power over time. For instance, £100,000 kept under your mattress with 3% annual inflation would only be worth £40,000 in today’s money after 30 years—a 60% loss in value.
To protect against this, you need investments that have the potential to grow faster than inflation, such as equities.
Longevity Risk - Running Out of Money
Longevity risk is the possibility of outliving your savings. As people live longer, this risk is becoming increasingly important.
Managing this risk involves careful financial planning. This often involves using tools like cashflow modelling and creating a retirement income plan that combines different sources, such as regular withdrawals from investments, income from annuities, and flexible drawdowns from pension savings..
Legislation Risk - Rule Changes
As we’ve recently witnessed, governments and regulators frequently change laws around taxes, pensions, and investments. These changes can impact your financial plan.
To reduce this risk, it’s important to diversify not only across asset types and sectors but also across account types - such as ISAs, pensions, and investment bonds - so you’re not overly reliant on any one structure.
Underperformance Risk - Falling Short of Your Goals
Perhaps the most underappreciated risk, underperformance risk is the danger of not earning enough to achieve your financial goals. For example, overly cautious portfolios might feel safe but fail to grow enough to outpace inflation or fund retirement.
Balancing this risk means adopting an investment strategy that aligns with your goals - one that takes on some risk to achieve the growth you need over time.
Conclusion: Embrace the Unexpected
Investing is about balancing the risks you take with the rewards you seek.
While volatility is normally quoted as the primary measure of risk, it is far from perfect and fails to recognise other crucial risks - like inflation, longevity, legislation changes, and underperformance. By recognising these, you can make more informed investment decisions.
Remember, volatility isn’t your enemy. It’s a natural and necessary part of investing that, when approached with discipline and a clear plan, can open the door to long-term growth. By focusing on a diversified, goal-oriented strategy, you can manage risk effectively and stay on track to achieve your financial goals.
Please note, this blog is for general information and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and it does not contain all the information which an investor may require to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is correct as of the date it is received or will continue to be correct in the future. We cannot accept responsibility for any loss due to acts or omissions made with respect to any articles.
