When it comes to money, people are often very unsure about taking a risk. The golden rule of investing, according to any investment textbook, is that younger investors should invest in higher risk asset classes while older investors should take on less risk.
On paper, this logic makes sense. Over the long term your investment will have time to recover and grow, even though markets and economies may go through temporary dips. But as investors near retirement age, it is best to be more conservative with their portfolio as this will soon be their only source of income on a monthly basis. Considering that investing is very seldom black and white, it always seemed to me that this was the one topic that everyone would agree on. That is, until I started working directly with clients. This so-called golden rule neglected to consider one very important point. Investors, especially younger, inexperienced investors, consider risk the ultimate enemy in their portfolio.
As we delve into the impact of risk, we first need to understand what is meant when we talk about risk. Investment specialists refer to risk as volatility. If an investment is up one day and down the next, and is very sensitive to any information coming into the market, we refer to it as having a high volatility, which indicates it is high risk. Conversely, if the value of an investment remains rather stable over the short term and movements are less volatile, we refer to it as being a low risk investment. To investors, however, risk means that their investment value is not guaranteed. It means that if the value of their investment – in a specified period – is less than what they have contributed. They then question if they would not have been better off leaving their savings in a simple bank account.
Unfortunately, as humans, we are conditioned to have a negative bias. Our reactions to bad news are more extreme than to good news, whether we are considering politics, the economy, a friend’s comment, and especially our investments. Let’s be honest, gaining R100 on your investment is nice but losing R100 can feel catastrophic. In the financial world this phenomenon is part of the field of study known as behavioural finance. This explains why so many investors truly fear risk in their portfolio. The idea that you might not have funds available to you in a time of crisis is terrifying.
Research, however, has shown that risk does not need to be feared. The reality is that your investments will rarely appreciate in a straight line, but that does not mean they are not growing. There is, in fact, another far more dangerous threat to your investments than risk. It is inflation. Unless you guard against it, inflation will eat away at your savings and the day you retire your investments will not be worth what you thought they were.
That R100 in the bank will not be able to buy you the same amount of electricity in 30 years, for example, as it will today. If you are looking for “a given” in the investment world, this is it: money loses value over time. The only way that your portfolio will be able to grow at a rate higher than inflation over the long term, is by exposing a portion of it to higher risk investments. Even if there is the chance of you losing money in the short term, the fundamental truth about higher risk investments is that you will be compensated for the risk by higher growth over time.
Although, risk will protect your portfolio from inflation, it does need to be managed by way of diversification. Diversification means having a portion of your portfolio exposed to higher risk asset classes such as equity, while having a level of protection built into the portfolio guard against these assets losing value due to unforeseen circumstances. The ideal ratio of risk assets versus safer assets is not a standard formula. Your personal situation, such as your investment goals, age, and risk tolerance, to name only a few, will need to be assessed to determine the structure of asset classes in your portfolio. A financial advisor can help you to analyse your situation and determine the appropriate level of risk for your portfolio.
In short, the golden rule is not broken. Younger investors need to up the level of risk in their long-term investments because they are the investors that will feel the effect of inflation more severely. Their investments are best placed to withstand the short-term volatility of higher risk investments. Risk is the most effective tool to be used to outgrow inflation over the long term. Remember, risk is like a Pitbull Terrier, it is intimidating and can be dangerous and scary, but if managed and trained right, it will protect you and will be a friend.
Written by Citadel Advisory Associate, Charné Olivier