Three steps to avoid excess financial risk
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How many times have you heard someone say that their acquisition of some asset “could prove a good investment”? The pivotal word in this statement, known as a modal verb, is ‘could’. It’s an inconclusive, non-committal word which, unwittingly or otherwise, sums up perfectly any comment regarding possible future returns.
Simply stating that ‘the value of asset Y could rise by 20pc a year’ is a prediction akin to saying that Southampton could beat Manchester City in this weekend’s FA Cup tie. Of course, the Saints could overhaul Man City, but the probability of an underdog success is reflected in bookmakers’ odds. Punters prepared to risk their money on a Southampton victory can get odds of 10/1 against it happening, but does that make it a ‘good investment’?
Inspired by an exhibition at Tate Modern a couple of years ago, a retired friend decided to ‘invest in art’, spending a five-figure sum on a painting he confidently expected to “appreciate at 20pc a year.” Asked how he could predict such stellar returns, he said the gallery through which he bought the painting had advised on this phenomenal rate of capital growth.
Driven by a protracted period of depressed interest rates initiated by the 2007-08 financial crisis, an insatiable appetite for yield has persuaded investors to accept greater exposure to investment risk. Moreover, there’s little to suggest that investor demand for income, a defining characteristic of the past decade, is about to grind to a halt, despite the recent rise in interest rates.
As a result, great swathes of investors have negotiated often poorly-mapped trails in search of capital growth. ‘Alternative’ investments are increasingly popular, with enticing headlines and frequently unsubstantiated returns captivating folks happy to invest in everything from airport car parking to allotments.
This begs the question: does investor behaviour over the past decade represent a form of blind complacency or a permanent shift in attitudes towards risk?
By remaining invested in ‘alternatives’ over the long term as they chase income, investors effectively take on greater risk, but this has done little to stop the flow of new ‘investment’ opportunities that could prove dazzlingly successful.
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Yet perhaps the most worrying aspect of what might be called the ‘new approach to investment’ is the age of people who are getting involved. Not many Millennials are snapping up seemingly high-yielding investments in hotel rooms. Nor do they appear ready to play the role of business angels and assign large chunks of money to an unquoted business in return for a seat on the board and the promise of future dividends.
By contrast, the risk tolerance of a burgeoning number of older investors is shifting upwards. Their portfolios may be underpinned by a solid core of equities and mutual funds, but there’s a high percentage allocated towards racier assets which could prove to be longer-term winners.
This marked change in attitudes towards an acceptance of greater risk needs addressing. Mindful of their longer-term needs and the understandable limitations of their assets, older investors should reconsider their portfolio objectives. This, in effect, is an expression of investment strategy – a pivotal premise that forms the basis of current and future planning.
There are three particular aspects of investment planning. First, consider your probable time horizon (an impossible poser to answer accurately). Second, take a more detached view of risk and the amount you’re prepared to accept in order to generate the required level of reward. Third, attention must also be given to your future income requirements. Do you wish to live like royalty in retirement, or are you prepared to sacrifice some luxury to ensure your assets do not expire before you do?
These preliminary steps will undoubtedly result in investors adopting a more realistic approach towards risk and start, or recommence, the process of comprehensive retirement planning. Once completed, it would pay to have your revised plan benefit from a fresh pair of eyes; ideally, this would be a professional financial planner who doesn’t have something to sell you that could prove a winner, but someone capable of taking a detached view of your investment objectives and advise accordingly.
For more financial advice, check out Peter Sharkey’s regular blog, The Week In Numbers.