The world of savings and investment is becoming more risky and the safest options are not necessarily the obvious choices
One of the immediate difficulties with any discussion of the risks involved in personal investment is that of defining terms. Everyone knows, for example, the accepted risk hierarchy of the investment classes on offer. It starts with deposit accounts where, as we all know, there's absolutely no risk.
Next on the ladder is government gilts and high-grade corporate bond issues.
One of the last resorts, in terms of risk at least, is to buy equities direct from the market. If the world still isn't flying past fast enough, though, thrill seekers can always rely on private equity investment to provide that added excitement or move into derivatives, options contracts and the like.
However, as Richard Boardman, director of risk modeling at Royal & SunAlliance (R&SA), says: 'While the ranking of the asset classes in the table is in line with conventional wisdom, there's a small problem in trying to impose this sort of wisdom on individual investors ' it's completely wrong.'
Essentially, there are two main reasons that, these days, it is no longer appropriate to simply identify whether a client is a low, medium or high-risk investor and to opt for investment classes accordingly. Boardman, explains: 'The first is that recent experience has demonstrated the standard assumptions to be just plain wrong.
'The second problem is that the assumptions upon which such lists are based are decades old. They originated when that friendly man from the Pru was still doing the rounds. Back then, investment products and their consumers were unsophisticated enough to make tick-the-box options quite suitable but this has changed dramatically in recent years. Advisers with an interest in correctly managing the risks within a portfolio need to pay more attention to the individual circumstances of the client and the financial ambitions they are trying achieve. There are two sides to the risk equation. One side deals with the perceived risks of the actual investment market itself ' whether it's equities, bonds or even futures.
'The other side of the sum is where the real risks come in. These are human risks such as if a savings plan fails to reach its target maturity, a person could lose the house they have occupied for 20 years or more.'
The problem with deposit accounts when considering risk is age old and results from a heavily entrenched misconception that it's impossible to lose money placed on deposit and that it is therefore risk free. The reality, of course, is quite different. There is something we call inflation and, especially in today's environment, inflation stalks deposit investors like no other savers.
With interest rates around their lowest for 40 years, Moneyfacts Magazine reports the average instant access deposit account pays only 0.49% per year for deposits of less than £5,000 and only 2.57% for larger deposits. That might sound reasonable but if you are a 40% taxpayer, the return falls to only 0.29% and 1.54% respectively. If you take into account the impact of inflation (the Bank of England's current target is for 2% a year), you are left with a running loss of around 1.7% a year for smaller deposits and around 1.03% a year for larger ones. Of course, it could rightly be argued that deposit accounts that require more notice offer more interest. 'But so they should,' comments Boardman, 'the link between risk and return hasn't been broken. Notice accounts are, by definition, more risky than instant access accounts, so you're still only getting what you pay for.
'The risk here is again a human one. Most deposit investors are either saving for a rainy day or regard the money as a buffer to help out in the event of a future emergency. The point is, though, when an emergency does arise, the investor can't access the funds they've been saving for months.'
Another way to consider the real risks of deposit investing is to compare the process with that of investing in a different asset class, such as equities. It has been a dreadful couple of years for equity investors but one piece of conventional wisdom that can still be trusted is that equities always outperform interest rates over significant time frames. This means that, over time, deposit investors are assured of losing out to equity investors.
Putting all this into the mix, the proposition for deposit investing goes from being the act of investing money you definitely can't afford to lose to investing money you know will underperform other assets and which, on withdrawal, is likely to be worth less in real terms than when you originally invested.
As Michael Lynch, director of sales at R&SA recalls: 'I remember meeting with a tied agent who used to ask clients considering deposit accounts why they didn't just buy a house with the money. 'After all,' he'd say, 'what do you think the bank is going to do with it?' This message hasn't really changed in the past 20 years but advisers have a mountain to climb when it comes to changing UK investor culture.'
The real story here is not that deposit accounts are wrong and that only equities can save the private investor. Deposit accounts are fine for those who understand the risks; unfortunately, it seems too few investors actually do. Looking down our original list again, it isn't long before we run into numerous other examples of risklexia (the inability of private investors to weigh up the real risk of their investment choices). Zeros, for example, hardly have the reputation they once did. Lynch observes: 'Only 18 months ago, senior IFAs were appearing in the press evangelising the zero and quoting marketing material that said 'no zero has ever defaulted'. This proved to be about as worthwhile a risk warning as telling investors no company the size of Enron had ever gone spectacularly bust.'Investment grade corporate bonds are still pegged about right in the table, although the flight to quality they've enjoyed at the expense of equities in recent years now means their low-risk returns will be expensive for new comers, thereby increasing the real risk. Guaranteed bonds are among the worst offenders. As Lynch explains: 'Many commentators are still rightly bemused by the regulator's failure to police the use of the word guarantee. Promising something that is conditional on a whole host of variables is hardly any promise at all. But many older investors, in particular, have fallen foul of such contracts.
'One of the worst abuses of investor expectations I've seen in recent years was a guaranteed bond linked to the Nasdaq index. It was a nightmare in terms of timing as the market nose-dived virtually from day one. When the dust settled, those holding this guaranteed bond were facing losses of 30% or 40%.' Company share schemes also seem to be misunderstood in terms of the risks. As Boardman explains: 'Probably because of familiarity, people naturally assume the company they work for is safe and therefore buying great chunks of the company's shares is also perfectly safe, not to mention tax efficient. In real terms, though, what are the chances of the company you happen to work for outperforming the rest of the equity market year after year? If investing in only one share (tax-free) was such a great concept, wouldn't more investors have made use of the single company Pep allowance when it was still around?'
With-profits funds are probably the biggest baddy of them all when it comes to disappointing investors. Sold as low-to-medium-risk vehicles with added smoothing, the number of mortgage holders who've been informed in recent years that their policy simply won't be able to meet the liability for which it has been funded for the past decade or more is nearing a quarter of a million.
It's not that equities, whether in fund or direct form, haven't disappointed in recent years, they have. But very few of those investors now nursing burnt fingers can claim they were sold the concept on the grounds of low risk. The fact is, today is just a more risky environment than we've encountered before. In terms of equity markets, for example, it means taking more risks, on a relative basis, in order to generate the same level of historic return.
As Mike Felton, manager of the R&SA UK Prime fund explains: 'In terms of modern investment returns, tomorrow isn't going to look much like yesterday. Investors were spoiled by the high inflation/high growth environment of the 80s and 90s but mainstream investors had better brace themselves for single figure equity returns for the foreseeable future. Inevitably, this means investors will need to come up with a different approach to the way in which they pursue portfolio diversification if they want to make the most of their savings.
'With low-to-medium-risk corporate bond funds now returning around 8% a year and equity funds, which are naturally more risky, only forecast to return about the same over the short term, investors should be considering all their options. Managing a private portfolio these days is all about absolute returns.'
That means disregarding whether a fund's returns are generated as income or growth and concentrating on whether savings are delivering the best level of return for the risk. History suggests equities are more likely to deliver outperformance over the long term but a mainstream equity fund will require investors to spend more of their finite risk budget in exchange for this potential.
Felton explains: 'Recognition of the lower return outlook for equity funds has prompted many fund managers to launch a new generation of aggressive focus funds that employ more concentrated portfolios to reward greater investment risks with greater investment returns.'
All this makes life more difficult for private investors concerned with the total risk of their investments and brings home the message that today's global economy requires a different approach when it comes to managing growth investments.
'After all,' says Felton, 'when companies are competing on a global footing, picking the best from each geographic region rather misses the point. In this environment, the only way to generate returns above and beyond those of a given index is to concentrate. This means concentrated portfolios that deliberately have a low correlation to the index in question.That might not sound like the most worthwhile advice for investors anxious to diversify their investments and so reduce the overall risk to their savings but, as Michael Lynch points out: 'In a market where most investors' portfolios are heavily skewed toward the UK and the FTSE Index, investing in higher risk funds that have a low correlation to the market is one of the best ways to reduce the total investment risk.'
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