Tuesday, 12 February 2013

The dangers of focusing on reward

One of my colleagues recently wrote an excellent paper focusing on risk. The dust has still not settled post RDR and it will not settle for some time to come. However, it is likely that more people will turn their hands to DIY investment initially and done right it can work well.

I recently received a marketing campaign from a direct provider. It was promoting or celebrating the 25th anniversary of a fund. If I had invested £10,000 25 years ago and re-invested all the dividends the fund would be worth a massive £180,000. Of course we are told that humans are rational beings however the reality is different. The marketing is very clever because you focus on the reward without considering the risk.

Let me take an example of what I do every day. I cycle five miles to work. I have been doing this for twenty plus years. Without thinking I am pre-set to consider the risks and take steps to mitigate the risks. So I have lights, helmet and reflective clothes. I also consider the route I take and may take a different route if the weather makes that route dangerous. My goal is to get to work and to get home. I also check my tyres, brakes etc before I leave. I possible don’t really think about it now - it is just part of the routine. Of course things happen which I can’t control, a car pulling across my path, black ice and debris on the road but these are hazards you have to accept.

However, sometimes we just look at the reward. I need to get somewhere quickly and the bike is the easiest way to get there. I can jump on the bike with no safety equipment and I might reach my goal but equally without things like lights and a helmet I am increasing the risk or danger of achieving my goal.

Investment risk is the same. We have all seen the graph which places cash and bonds at the lowest end of the risk spectrum and equities at the top and this is all we see. However as humans we are not always rational when it comes to investing in fact we are inpatient and want to make a quick return.

Going back to the example the focus is on the reward, there were four pages talking about the fund and even an interview with the fund manager. It may have discussed the risk but that seemed irrelevant and it would be interesting to consider how many invest on the back of that, it would then be interesting to see how many ride the whole course and how many jump at the first hurdle, and after twenty five years how many are happy with the return or disappointed.

Risk aversion is one of the biggest fears, but we must tackle this head on. If I have £10,000 in cash which I know I will use each month over a 12 month period then holding in cash is possible the best route, it could be used as an offset on the mortgage or earn a tiny bit of interest. But I know in real terms with inflation I am losing money on this. However, if I don’t need that money should I be holding it in cash?

Cash is dead, this is not a fear story it is the truth I can print many stats to support this. Twenty years ago cash was used to provide an income through the interest, this can no longer be done. Interest rates could go down and possible they won’t go up until 2017. Inflation is likely to go one way over the long term and that is up which means in real terms cash will be killed.

Of course bonds are the alternative option but a word of caution; bond returns do not reflect the underlying market. Investors will see the long term returns and not consider the future risks. With all bubbles the danger point is at the euphoria. I am sure if we are honest we have all been there, with the dot com bubble funds were going up 100% in a year and we wanted a bit of that. In reality the party had finished and it was just a matter of time before the whole bubble went crashing down.

When it comes to investing the risk is in not doing your homework, and getting the right equipment to deliver. You also have to accept that events happen which you cannot control. Retirement has changed we will live in the main for twenty years in retirement. If you were forty would you hold all your money in cash for twenty years, of course of you wouldn’t?

So how do you consider risk and not get sucked into the marketing. Understanding risk is important, there are different explanations:

“the uncertainty that exists as to what the eventual outcome will be” – Rozskowski and Davey 2010

“risk is a permanent loss of capital and not volatility” – James Montier

“risk comes from not knowing what you are doing” – Warren Buffett

I have argued that the first step is for us to understand what our goals are, and consider whether these are realistic. Once we have considered the goals then we have to consider how we will deliver those goals. I read a brilliant article that set out some questions around risk:

How much risk are you prepared to take to achieve your goals? 

How much risk do you need to take to have a reasonable chance of achieving sufficient growth to achieve your goals? 

How much risk can you afford to take?

You can only consider these against your goals. With our investments we have taken some additional risk by investing directly in shares however I have done my research I have also set trigger points and because of timescales I believe we can afford to take the additional risk. I had a tax bill to pay and I set aside some money to pay that bill, I could have invested that money but instead I held in cash because I couldn’t afford to take any risk with that money. So different goals have different risks.

In summary it is very easy to focus on the reward but before being sucked into glossy marketing or headlines focus on the fundamentals. One final bit of advice diversification is key, you can have cash you can have bonds and you can equities but you need to dig deep and think differently and not necessarily follow the herd.

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