Generally with investments, the higher the hoped-for return, the higher the risk involved. There’s no such thing as a free lunch. However, many people are not comfortable taking what they consider to be high risks. How can people understand the level of risk associated with different types of investment and how can they determine their appetite for risk so that they can make appropriate investment decisions?
The primary goal of investing is to preserve purchasing power and keep up with inflation, says Daniel Moroney, investment strategist at RBC Brewin Dolphin.
“Investing first principles is doing something with savings other than leaving it sitting in a bank account,” says Moroney. “Historically, if you’re lucky, your cash deposits have kept pace with inflation but in many cases they haven’t, so leaving a significant amount of money in the banks will see their purchasing power eroded over time.”
While this doesn’t mean that €1,000 in a bank account will be €950 in 10 years, it does mean that what you can buy for that money in 2024 will most likely be reduced in 2034.
If someone is looking at the investment world for the first time, it can be daunting as there is a lot involved, says Kevin Quinn, chief investment strategist, Bank of Ireland.
“The first thing to consider is, what am I trying to achieve with investing? You’re trying to grow the real value of your wealth – that is, its purchasing power.
“Next, you need to think, what are my immediate expenditure plans? What am I thinking of spending in the short term and medium to longer term and, after that, how much money do I have left over? If there is surplus cash, what do you want to achieve from it?”
Consider how much money you have, what you want to achieve from it and how much time you want to invest it for, says Quinn. Think of asset risk as a continuum, from cash – being low risk – to bonds.
“Next up is risk assets,” he adds. “That’s a family of several different types of assets: public equity, property and then, at the riskier end, private equity. Most people won’t be able to access all those classes, so they will tend to do it via funds. Funds are pooled investment vehicles categorised by risk.”
The industry uses a number system of three, four, five and six, with a mix of high and low-risk assets in different ratios depending on the risk factor. The Central Bank and financial textbooks classify investments as high risk or low risk based on volatility, says Moroney.
“A share or a stock market can rise or fall 20-25 per cent a year, which happens not infrequently,” he says. “Cash will never fall by that much. Cash is very stable, whereas the stock market can go up or down violently. In a short-term time frame, there’s no doubt that volatility is risk and cash is safer.
“If we’re thinking long term – which nearly every investor should do – you flip it on its head a little. If you sit on cash for 25 years, history tells us, you’re probably going to lose purchasing power. It may nominally increase in the bank but inflation eats it away.”
What protects against inflation? Volatile shares, says Moroney: “If you buy high-quality shares and diversify, that will be volatile in the short term. But over 20 years there’s no doubt to me that cash is riskier over the long term.
“In the short term there will be plenty of times when the portfolio will decrease but any reasonable assessment of asset classes will tell us stocks are much better. And part of the reason they are is they are volatile and it’s hard to hold on when the market falls over 20 years. If you can put up with the volatility you get rewarded for it – but it isn’t easy.”
So, investors must put up with short-term volatility but assets categorised as high risk become lower risk the longer you hold on to them. The low-risk asset – cash – becomes higher risk the longer you hold it.
“If the time frame is two years, stocks are risky and cash is safe, but if it’s 20 years, cash is risk and you’re more likely to avoid the risk with stocks,” says Moroney.
When someone consults an investment adviser they are typically taken through a questionnaire which will give an indication of their risk appetite, says Quinn.
The process involves exploring what trade-offs people are comfortable with, how long they could endure any loss and how much volatility they are likely to be able to withstand, and thereby establishing the type of risk most suited to them.
“This is where the adviser is tasked with explaining the trade-off with risk and return,” adds Quinn.
Is an investment adviser even necessary? In theory, investing for the long term is simple, says Moroney: “You diversify, buy high-quality assets and leave them for a long time. Why would you need an adviser? But an investment adviser can earn their keep when it comes to periods of extreme volatility – for example, when Covid hit.
An investment adviser fails when they make a plan for an investor and the first time there’s a wobble the investor wants to abandon the plan
— Daniel Moroney
“Also, there are bear markets quite frequently and the average fall for the US stock market is 15 per cent per year. The stock market falling in double-digit percentages is normal, it tells us we shouldn’t be too concerned.”
A good investment adviser can be instrumental in protecting an investor from doing what might seem instinctive and selling at the first sign of a fall.
“If you sell at that point, you’re making a mistake,” says Moroney. “The person who has a sensible plan and sits tight over 30 years will almost certainly do better than the person who wobbles when the market drops and then buys in again.
“People think a good investment adviser is all about what they pick and the timing, but I think the best thing a good adviser can do is protect the investor from the extreme fears that naturally occur and remind them of their sensible plan and to stay the course when there is a wobble – as there inevitably will be.”
As with everything to do with investments, good advisers are conscious that they are dealing with people’s savings, Moroney says.
“An experienced investment adviser can really help,” he adds. “An investment adviser fails when they make a plan for an investor and the first time there’s a wobble the investor wants to abandon the plan. They have failed the investor and failed to properly judge their appetite for risk.”