We all think we know what investment risk is – the huge volatility you get from Bitcoin, Hedge funds and Penny Stocks. Leave them alone and you’re okay Jack!
Unfortunately, it is not that simple.
Financial advisors are obliged by the FSCA (the old Financial Services Board) in terms of the FAIS Act to assess the risk for clients and come up with a risk profile. For many brokers this is just a box ticking exercise for compliance, based on a questionnaire that is at least 20 years out of date. Determining risk for a client and their investment should be way more than a CYA (Cover your a##) exercise and is much broader than you think.
The risk that most investors are concerned with is really their “risk appetite”. That is how we ‘feel’ about risk. This is usually a byproduct of our upbringing and life experience. In those old-fashioned ‘risk profiles‘ done by brokers, this risk appetite plays the most important role in determining the investment structure. I am not saying that this is unimportant, far from it. The last thing any of us planners want is a client that is constantly anxious about their investment, we need to validate and understand our client’s fears but also make sure they understand the implications of their beliefs.
Take a client with a low risk tolerance as an example. It may be comfortable for them to place their funds in safe money-market and fixed-income assets (which ironically would have stood them in good stead over the last few years.) Over time however, this may prove to be the wrong thing to do as hard-earned capital can never achieve the desirable compounding rate offered by more volatile equities over time. So, not only is taking cognizance of risk appetite important but the contribution rate, time to retirement, and investor objectives are just as important.
Ultimately a good advisor combines all these variables factors and expresses a client’s risk appetite which is as unique as the individual. This nuanced approach makes nonsense of the rules of thumb used by lazy brokers to determine how much you need to save for retirement. There is no magic number or percentage. We all know we are unique, how then can there be one answer to fit all? Sure, we all love simplicity, especially if it means we don’t need to pay someone to manage our investments, but investing for something as important as retirement is unfortunately not simple. The greatest risk of all is running out of retirement funds before you (or worse, your dependents) pass.
Most of us who have investments are familiar with the risk posed by different asset classes, a risk usually associated with a possibility of losing capital. The least risky is cash – not cash in the sofa on your game farm, but money-market investments. Stocks are the riskiest because they can be volatile. When one thinks about the risk posed by various asset classes it is equally important to understand the importance of time. Consider the following: When one invests in the money market, there has not been an instance of negative returns over any calendar year since 1976 whereas local equities produced 10 calendar years of negative results. This may seem high to you but also consider that equities have produced a real return of 10.8% p.a since 1976 whereas the cash real rate has only been 1.5%. So, if an investor has time on their hands, the ownership of equities should be a no-brainer. Investors should ignore complicated financial instruments such as leverage as these can lead to complete capital destruction and can even put you in debt.
Entrepreneurs, often unencumbered by pension fund schemes and such, have usually escaped the claws of insurance products, but also fall into another risk trap – asset concentration. Asset concentration is the risk that comes from not diversifying and by default having too much invested in a single asset, single region, single sector etc. Entrepreneurs who invest exclusively in their own company, create that asset concentration risk. DIY investors often fall into the Asset Concentration trap – buying a winner and let it build up a higher and higher proportion of a portfolio as its price escalates over time. Over-investing in property is a common mistake. Even though the gain is good for overall returns this does pose a concentration risk when the underlying company or sector falls on hard times. Understanding how and when to diversify this risk is the secret sauce of wealth managers. Considering the client, their time frame an ultimately their overall objective allows a professional to act with prudence.
Currency risk on your offshore investments is often ignored in the mad dash to get money out of SA Inc. Currency risk acts as a multiplier on the other asset classes. In other words, in addition to the normal up or down movements that you can expect from an asset class, the appreciation or deprecation of the Rand can make those returns much better, much worse or flatten them completely. Forex can add a whole new layer of uncertainty to your investments that will need to be decoded – especially if those investments have to be factored into your retirement. Just a heads up – don’t be sucked into offshore Trusts, Quasi Trusts and other investment vehicles that you don’t fully understand. As a South African tax resident, you are going to be bound by SA Tax law and you aren’t exempt from the Trust and Tax regulations that have made Trusts a fraught and expensive planning tool (a full article on this topic to follow shortly.)
There are other risks that you might not think about:
Running out of money in your retirement, the impact of high fees, government regulation and the propensity to kill the golden goose, overconfidence in your ability to save for retirement later rather than sooner and the downside to longevity. I will deal with all of these in a future article. In short, make sure your Planner works with you to understand the risks in your wealth portfolios, and marry those to your risk appetite. This is too important to be a tick-box compliance exercise.