I regularly emphasise the importance of not deviating from an investment strategy when markets move up and down.
Every investor wants to make a fortune in the shortest possible time and the maxim ‘how to make a small fortune quickly is to start with a large one’ seems to be the only way.
Investors wanting to receive maximum returns have to take maximum risk but, conversely, the concept that the greater the risk, the greater the return, is a fallacy. Ask those who got involved in Ponzi schemes.
It boils down to the risk:return ratio which is a fundamental investing principle. The ratio can be interpreted as risk and reward, as in how much risk must you take to ensure you are aptly rewarded? Whenever you invest for growth there is risk, whether large or small.
What’s your risk profile?
With the new compliance regulations, financial advisors are compelled to record the advice given to a client and, as part of the advisor’s recommendations, a risk questionnaire needs to be completed which gives a corresponding score. Scores then determine the investor’s risk profile.
On a scale between low and high risk, those who stick to low risk are considered conservative investors. Those who favour high risk are considered aggressive investors and a middle position is moderately conservative or aggressive.
Investors feel inherently comfortable with their choice on the risk scale. Conservative investors are happy with their low risk profile, particularly when markets are down and there’s a lot of volatility, as they feel their decision is justified.
Regrettably, they rarely see these as great investment opportunities for the future and that their ‘comfort zone’ will cost them dearly in the long term. Aggressive investors feel their decisions are justified when markets are moving forward and they are able to see the volatile times through.
Finding your fit
It’s important to understand that there is no right or wrong position on the scale. But I see many investors remaining in their chosen category, even if it’s the wrong choice for them. By staying within their comfort zone when markets are down, they will miss out when markets recover as, I assure you, they always do.
I believe that the responsibility of a financial advisor is to understand, in consultation with the client, how much they need to accumulate for retirement and then assess whether their chosen risk profile is likely to provide what is needed.
For example, a moderately conservative investor may find they are taking too little risk and may retire with insufficient capital. By asking this question, the investor and advisor may need to raise the risk profile one or two notches. Remember that your financial advisor should not be taking you where you want to go with your investments but rather where you ought to be.
What’s your goal?
There are other criteria which determine an investor’s risk return profile. These relate to timeframe and their net worth.
Timeframes determine that any investor who anticipates needing a large sum of money in the short term cannot consider taking any risk. In my opinion, a one to three year time horizon is more a ‘saving to spend’ outlay, which cannot be viewed as investing for the long term. Those with long-term time horizons can afford to wait and ride out price fluctuations and the longer the timeframe the more likely they are to reap the rewards of quality investments.
The majority of global banks and institutions garner clients who want great returns and growth but want to take little or no risk.
I believe there is really only one question which needs to be asked and that is, “How would you feel if you lost 25% of your capital in the next six months?“ Few would be happy unless they fully understand the risk: return ratio and the effect of this on long-term growth.