I regularly discuss investment risk with people. It is, after all, a regulatory requirement to assess and regularly review clients’ attitudes to investment risk as well as their capacity for loss. What I have discovered is that most clients’ initial perception of investment risk is very different to the true investment risk. Unfortunately few could blame clients for thinking that investment risk is the risk of absolute loss of their capital.
However, in reality, the “risk” for most people is, in fact, the shorter term fluctuation in the value of their investments, the volatility, rather than the risk of permanent loss of capital.
The problem is that the FCA measures risk primarily by the volatility of investment valuations rather than by the risk of absolute loss of capital. The FCA does recognise and warn investors against permanent loss of capital too but when it does so it goes too far by banning investment in high-risk assets such as cryptocurrency (marketed by UK providers to UK investors) altogether other than for professional investors. By all means, warn investors of the investment risk but then allow investors to decide whether to invest or not. They are adults after all. Whatever happened to caveat emptor?
The issue with measuring investment risk by volatility is that it is a very poor measure of risk in my opinion. Volatility is not risk. Volatility is volatility. Period.
The risk of permanent loss of capital, on the other hand, is true investment risk. Absolutely.
Let me illustrate what I mean by way of a graph below.
The above graph shows the investment return of the Parmenion Strategic Passive portfolio (12-15 funds) over the last 10 years to 1.7.21. The portfolio consists of the four main asset classes of cash, property (commercial property), equities (shares) and bonds (corporate and government bonds). For investment risk grades 1 to 10. 1 being the lowest and 10 being the highest. At the lowest investment risk levels there is a relatively high amount invested in bonds and property with a very small amount invested in equities. As the investment risk grades increase, proportionately more is invested in equities and less in bonds and property.
As you can see from the graph, over a period of 10 years, every increase in investment risk grade results in a higher investment return. This backs up every study I have ever read on the subject of investment. Over the longer term, periods of 10 years or more, shares have always outperformed all other assets classes including property on at least 90% of occasions.*
Do shares fluctuate in value? Absolutely. Is there a risk that some companies within a portfolio could fail? Yes. However, within a typical portfolio of, say, 750 shares (15 funds x 50 shares) like the Parmenion Strategic Passive portfolio, how many of those companies fail in a year? Well even during the last 16 months of the Coronavirus pandemic very few if any companies in this portfolio have failed. So how risky is that? Not too much unless you are reliant on a high income from your investments. So I put it to you that an investment in a large, diversified portfolio of assets over a period of 10 years or more is not high risk, but you will experience volatility.
If on the other hand, you were to invest a large proportion of your investable assets into a single company for a short period of time then you would be taking very high risk indeed because you would be putting all of your eggs in one basket. What’s more, if the company were to fail you would lose your entire investment because there is no investor compensation for single share investments. That is risk. Permanent loss of capital.
Furthermore, the investor compensation scheme is not available to protect your investment in a single company share whereas a fund has investor protection of £85,000 per fund management group per person.
Using the Parmenion Strategic Passive portfolio as an example an individual investor has £1,275,000 investor protection in a portfolio of 15 funds with 15 different fund management groups. A joint investment by a couple doubles the investor protection available to £2,550,000. Pretty good, eh?
What’s more all collective investment schemes (unit trusts and OEICS) have independent custodians which are usually large banks. This means that your fund investments are registered in the names of these custodians. If the funds were to fail then the fund management groups could not touch the money as it is ring-fenced. A fantastic safeguard for investors.
Those of you who remember the Barings Bank failure as depicted in the film Rogue Trader will recall that the trader Nick Leeson brought down Barings Bank through negligent trading. The bank had a fund management arm called Barings Fund Managers. Depositors in Barings bank accounts lost 100% of their deposits above £20,000, the then investor compensation limit of £20,000, whereas investors in Barings funds lost nothing. The reason for this was because all of Barings funds had independent custodians so investors’ money was protected.
So the message is that long term investment, 10 years or more, in a portfolio of collective investment schemes, OEICs and unit trusts, offer investors very high levels of investor protection. They also offer the highest investment returns if your money is mainly invested in shares.
There is an argument that long term investment in collective investment schemes primarily invested in shares are lower-risk investments than bank accounts. In the 60 year history of the Investment Association, no investor has experienced a loss of money due to the collapse of a fund. During that period a number of banks have failed such as Barings Bank and lost investors money. A permanent loss of capital. That is high risk. Absolute risk of loss of capital.
I believe it is high time for the FCA to re-define investment risk as volatility, not risk. True investment risk is the risk of permanent loss of capital. You know it makes sense.**
* Barclays Equity Gilt Study
** The value of your investment can fall as well as rise and is not guaranteed. The contents of this blog are for information purposes only, are based on my personal views and do not constitute individual advice. You should always seek professional advice from a specialist. All information contained in this article is based on our current understanding of taxation, legislation and regulations in the current tax year. Any levels and bases of and relief from taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future.