Personal Finance 5: Risk
by George Hatjoullis
The distinction between saving and investment is somewhat blurred in finance but for the purpose of this series of lessons saving is restricted to those activities that involve no risk of nominal loss. Hence, an instant access savings deposit with a bank under £85k is ‘saving’. You are as sure as is possible that your deposit is safe. Of course, even a deposit can incur a real loss if the inflation rate exceeds the after tax interest rate but the issue of real returns is more complicated than it seems and will be addressed at a later stage. Investment is the purchase of any asset that might involve a nominal loss. Hence, in principle, a deposit above £85k is an investment since it is not insured by the FSCS. All marketable assets are potential investments as the holder may incur a loss on sale. A gilt is secure if held to maturity but if sold before maturity could involve a loss. A gilt is thus an investment. Indeed a fixed deposit of less than £85k is, strictly speaking, an investment if there is an interest penalty on breaking the deposit. The point of the distinction is to emphasise that investment always involves the potential for loss.
ISAs and pension plans are not investments. They are investment wrappers that contain investments. The wrapper defines the tax status of contributions into and withdrawals from the wrappers, and the assets contained within. The investments are the underlying assets. An asset is anything that offers potential for capital gain (selling at a higher price than purchase) or promises an income stream. The risk arises because the asset value could fall to zero or the promised income stream does not materialise. Once again, investments are about risk and potential return.
The two basic investment vehicles are debt and equity. The characteristic of debt is that it is a contractual obligation. Hence, in the case of a loan there is a contractual obligation to repay the amount of the loan plus interest on some specified time path. The risk is that the debtor does not meet the terms of the contract. This is a ‘risk’ to both the creditor and the debtor. This is known as default risk and the concern of the creditor is the loss at default. The loss need not be the whole amount of the loan. The characteristic of equity is ownership. The equity holder owns a claim on the asset and any benefits arising from ownership of the asset. If the asset is an enterprise then the equity holder has a stake in the benefits and the risk that there are no benefits or that the enterprise completely fails. In the case of debt, the creditor has a contractual claim on the debtor whatever but in the case of equity, the equity holder has no residual claim on anyone if the enterprise fails to deliver. An interesting contrast between these two types of risk is provided by none other than William Shakespeare in his ‘Merchant of Venice’. The blog post ‘The Merchant of Venice‘ (http://bit.ly/1fYHvWX) is worth reading before continuing.
The key element of risk management is diversification. This concept is less obvious than it at first seems. First, it is hard to achieve if you only have a small amount to invest and it may be expensive to do so. Second, it is equally hard to know to what extent you have achieved desired diversification. Third, some risks simply cannot be diversified away. The idea is to hold a portfolio of assets that at any point do not perform in the same way. One asset may be doing well whilst another is doing badly. The net effect is a portfolio return not as good as the best but better than the worst. Diversification thus helps reduce the specific risk of holding a particular asset. However, there are some risks that affect all assets to some degree and it is not possible to eliminate this source of risk except by not holding the portfolio of assets. This is often called the system risk or ‘systemic’ risk as it is intrinsic to the economic system or environment.
The cost of diversification for the small investor can be high and often not transparent. The obvious way to achieve diversification is to invest via a collective investment vehicle. Someone puts together a bundle of assets and individuals buy a share of the bundle or fund. The entity putting together the bundle is likely to charge for the effort and the charges can have a big impact on the final return. If you invest £1000 for 30 years at an average return of 5% you will have £4320.19. What if there is a 1% ‘management’ charge? Your 30 year value is £3243.40. This is a third less. It is worth paying close attention to charges and asking if the diversification achieved is necessary or even what it seems.
Another vital consideration in investment decisions is timing. Assets prices go up and down. Sometimes trends emerge that can last a long time and move along way. For the non-professional investor (small or large) trying to time markets is ill-advised. The best approach is to not commit all at one time. Fortunately, most small investors accrue cash to invest slowly over time so this process happens naturally unless it is deliberately circumvented.
Two other risks concepts are worth noting and will be bandied about by the semi-informed. First, there is ‘fat tail-risk’. This comes from the idea that the possibility of extreme outcomes is greater than is assumed by investors. The usual focus is on extreme bad outcomes but it may be that extreme good outcomes is equally underestimated (it depends on the shape of the probability distribution being assumed to generate the outcomes). There may be a fat tail-risk in the UK property market at the moment and it is arguably being encouraged by the Bank of England via the forward guidance it is providing on the path of interest rates. The affordability of house ownership is being sustained by low interest rates. Those taking out mortgages should be undertaking a sensitivity analysis of their financial situation to judge at what level of mortgage rates they would find themselves in difficulty, other things being constant. It is likely that such exercises are not undertaken and even when they are, the probability of the critical rate being achieved is underestimated. The mortgage loan is, after all, long term and things can change very abruptly. The second, risk concept is usually called the Black Swan. This refers to an event that has not been included in the risk assessment. It is a complete surprise. This does not mean it should have been though. The bail-in of Cyprus banks last March came as a complete surprise the majority of Greek-Cypriots. For them it was a Black Swan event. However, it should not have been as there was plenty of evidence that it was a serious possibility long before the event (see the various blog posts on the Cyprus crisis).
It is impossible to completely eradicate risk in investment and it is not desirable either as the return would be commensurately low. It is however vital to understand the true risk involved and be sure that it is desirable to take such risk. If the risk is not adequately rewarded then look elsewhere. For example, cash deposits in the UK are not insured above £85k. It makes no sense to keep more than £85k per person per licensed institution unless there is a substantial interest pick-up for doing so (and possibly not even then). At the moment I know of no institution offering such a pick-up so if you have more than £85k in the account ask yourself; why?