A report released this month in the US revealed that investors are playing it too safe to achieve their retirement savings goals. The report interviewed more than 1 000 investors between the ages of 50 to 75, and found that of those surveyed, 80% prioritised discussing risk tolerance.
As an investor, risk tolerance is key to your financial freedom. While all investors want to avoid losing capital at all costs, playing it too safe, or being too conservative, can result in the loss of long-term returns.
Regularly, clients, such as retirees, invest too conservatively in fear of the volatility of their investments.
In the short run, their money is probably safe, but the returns that a money market fund offers may not keep up with inflation over time. In the long run, returns will not be enough to sustain them in retirement.
If risk is underestimated, the ups and downs may be too much to bear for an investor and it may force them to withdraw before an investment has had time to give them their required returns, or they may exit at the worst possible moment.
The way you think about risk relative to performance, and the individual tolerance that you have for this is important, as it influences the investment choices you make.
A successful investment is when there is a match between the risk you expect and the actual risk of the fund. Calibrating your risk tolerance is a problem of psychology and the most difficult psychology to solve is often your own.
The way you think about risk is influenced by your culture or generation
The risk perceptions of millennials are markedly different from that of their parents’ generation and of their grandparents’ generation.
A US study done by Legg Mason about the views of millennials on investment shows this in practice: 85% described themselves as conservative investors, with a lower portion of their investments in equities compared to that of their parents’ generation, despite the age difference. Millennials experienced the disruption of the global financial crisis up close either directly or through their families. It is no surprise that this left a risk-averse mindset in its wake, especially in the more impressionable generation that experienced it early on in life.
Wealth and cultural differences also play a role in what you may view as risk. Growing up in a home where money and investing are spoken about openly will make you more comfortable with taking on market risks than someone who has to learn about it later and on their own.
So where does this leave us as investors?
Formby suggests to think about what “risk” means to you. You can do this by doing the following:
1. Determine how risk could impact you. What are you trying to avoid? Losing money, poor performance over a long time followed by good performance or performance that fluctuates. Often it is less scary than the permanent loss of money that the term ‘risk’ evokes.
2.Work out your tolerance levels. Under what conditions would you become uncomfortable and how likely is that to happen?
3.Match the risk tolerance with the kind of investment you want to make. Generally, the higher the equity exposure, the higher the fund’s risk.
Get involved in how your money is managed so that you can take ownership of your financial future. And do your research. If you do this you can adjust what your perception of risk is so it matches the investment you choose.
Rob Formby is the chief operating officer designate at Allan Gray.