If you don’t want to see your investments fall in value, then choose a strategy that doesn’t invite risk. Top financial adviser Anna Sofat explains where to start.
Investment markets have more than doubled over the past eight years. It’s tempting to think stock prices will carry on rising, but no one knows whether this ‘bull run’ will continue.
Regardless of what the pundits might say, if you can’t afford to see your investments go down or are the sort of person who can’t bear the thought of that happening, low-risk investing is right for you.
A cautious investment fund or portfolio of assets won’t shoot the lights out, but nor will it crash and burn if markets take a turn for the worse. Conversely, a higher-risk portfolio will probably deliver higher returns, but this outperformance is not guaranteed. If markets turn sour, then your pot will be hit hard. Professionals call this effect the risk/reward ratio.
Which level of risk is right for you?
You need to understand both your personal attitude to risk and the amount of risk you can afford to take.
The less spare cash you have, the less risk you can afford to take. For example, if you are retired and your only resource, aside from your state pension, is a fixed amount of savings, then your priority must be to secure sufficient income to guarantee you can meet your essential outgoings. If you already have enough income to meet your essential outgoings – for example, from your earnings, a final salary pension or buy-to-let property – you can afford to take more risk with other assets.
Your personal attitude to risk is determined by hard-wired psychological traits that make up your personality. Ask yourself how important is trying to achieve high returns and what emotional response would you have to a 30% drop in the value of your investments?
Cash on deposit is secure and easily accessible. However, with inflation running at 3% and average interest rates running below that, your money may be safe, but it is likely to be losing value in real terms. Deposits are government backed up to £85,000 per institution, so if you have more than that, spread your cash between different institutions.
Annuities are a secure way to deliver a guaranteed income in retirement, insuring you against outliving your fund by paying out for as long as you live. They can also hedge you against inflation increases. A healthy 65-year-old would pay £100,000 for an index-linked annuity paying £3,100 a year.
Peer-to-peer (P2P) platforms allow investors to lend money directly to individuals and businesses at higher rates of return than cash on deposit. In return, they receive an attractive yield – provided the borrower does not default. They have delivered (mostly) without problems for several years, but if things go wrong, your cash is not guaranteed.
Investing directly into the stock market is one way that low-risk investors can beat cash deposit rates, but this is not guaranteed. Most financial advisers offer risk-graded portfolios for investors of different risk profiles.
Structuring risk on a scale of one to 11
My own firm, Addidi Wealth, structures portfolios on a scale of one to 11. The portfolio that is risk grade 1 is ultra-cautious, comprising of cash on deposit, gilts (government bonds) and high-grade corporate bonds (loans to companies). It doesn’t contain high-risk assets, such as company shares (also called equities), commercial property, and derivatives (contracts to buy or sell underlying assets – they include options, swaps and futures contracts).
As the portfolios move up the dial from one to 11, the exposure to high-risk assets is increased by 10%. Portfolio risk grade 11 comprises entirely of high-risk assets.
We analysed the performance of portfolios with different risk levels in the 27 years between 1989 and 2016. We looked at rolling time period returns – the annualised average return for a period ending with a particular month. Rolling returns are useful for examining the behaviour of returns for holding periods similar to those actually experienced by investors.
The research highlights three key issues for investors:
- The more risk you take, the more likely you are, on average, to achieve a higher return.
- The more risk you take, the greater the chance of you either overshooting or falling short of that potentially higher return by a big margin. Conversely, the more cautious you are, the closer your actual return is likely to be to the predicted target return.
- The length of time over which the investment is held is very important. For all portfolios, the difference between the best and the worst outcomes shrank over time. The key message here is that the longer your investment horizon, the more risk you can afford to take, even if you are a cautious investor. Over 20 years, the worst-case scenario average annual return for the 100% risk assets portfolio is, at 4.2%, higher than the 3.8% average annual return for the zero risk assets portfolio. So a cautious investor would probably be at ease with a 20% risk assets for a 10- year investment horizon, but could stomach 50% risk assets for a 20- to 30-year investment horizon, such as saving for a pension.
CASE STUDY 1: When a cautious approach pays off
Peter, Paul and Mary are all 55 and each have £100,000 they want to invest for 10 years to spend on enjoying their retirement. Their final salary pensions will cover their basic income requirements.
Peter has invested in the stock market before and is comfortable with risk. He opts for an aggressive 100% risk-based portfolio.
Paul hasn’t really thought about his attitude to risk, but is impressed with Peter’s track record of making big money from investments, so copies his 100% risk-based portfolio.
Mary has conducted an online risk assessment, and has concluded she is a low-risk investor. She opts for a 20% risk, 80% non-risk portfolio.
Unluckily, for all three, markets nose-dive just after they invest. Three years later, as the bear market persists, Peter and Paul’s £100,000 pot has shrunk to £64,005.
Peter holds his nerve and remains invested because he is confident that his fund will rebound within the 10-year period. But Paul finds he can’t take the prospect of further falls and withdraws his cash and puts it on deposit at the bank. Mary’s more cautious pot has fallen to £95,771, but she feels confident riding out the storm.
Markets recover slowly, but unluckily for all three, this 10-year period is the worst on record.
At the end of the 10 years Peter’s pot has grown – but only to £101,083. Paul has subsequently earned just 1% a year at a building society, making his fund worth £65,944. Mary’s fund was back in the black within five years and at the end of the 10-year term had risen to £120,828. On average over all the years in the stock market, Peter’s strategy would have beaten Mary’s but, on this occasion, it did not.
CASE STUDY 2: Picking a safe withdrawal rate for retirement
Jane is 62 and plans to retire from work at 65. She owns her own home and is on course to receive an annual state pension of £5,000 and a final salary pension income of £2,000 a year. She also has £100,000 in a defined contribution pension pot, after having taken her tax-free cash to clear some debts, and a further £120,000 in a stocks and shares Isa. She is no longer contributing into either pot.
She thinks that £12,000 a year will be just enough to live the lifestyle she wants to live, with £15,000 a year for her to feel comfortable. She describes herself as very risk-averse. By converting her £100,000 pot into an annuity, Jane can secure herself a guaranteed income for life of £3,100 a year, index-linked.
Her £5,000 a year pension – £100 a week – is well short of the £159.55 a week full state pension, but she buys 10 years’ extra benefit at the rate of £741 for each extra ‘year’ of NI contributions, worth £230 a year. By using £7,410 from her Isa, she boosts her state pension by £2,300 a year.
She now has secured, inflation-protected income of £10,400, just £1,600 short of her £12,000 comfort target.
She needs the remaining £112,590 in her Stocks and Shares Isa to deliver at least £1,600, and ideally £4,600 a year for her to be comfortable.
Deciding on a safe withdrawal rate for a retirement pot is not easy. If markets fall in the early years, big withdrawals will erode the pot further, giving it less scope to recover when markets come back. She opts for a cautious 20% risk asset portfolio and holds two years’ income in cash as a buffer to enable her to see out troughs in the market.
A 4% withdrawal rate would give her £4,500 a year, just short of her target, but Jane decides to only takes this level of income in good years, and trim her withdrawals to half that figure in years when markets fall by 20%. This considerably increases her chance of making her pot last.
A good way to assess your attitude to risk is through an online risk profiler. I recommend the one from Standard Life at Standardlife.co.uk/c1/guides-and-calculators/assessyour-attitude-to-risk.page. It has been developed by Oxford Risk, an independent team of leading psychology academics originating from Oxford University.
Anna Sofat is managing director of Addidi Wealth, the financial services planning company specialising in female finance.