The pandemic is a reminder that risks in life come in many varieties and dimensions – and investing is no exception.
In terms of Covid-19, the risks concern such questions as whether to stay indoors or go out, whom to visit, and if and when to re-engage the cleaner. Then, with death and illness so salient, many of us find ourselves contemplating these possibilities more frequently than ever. And, of course, the pandemic has affected the investment market and the value of our savings.
We tend to think of investment risk in a single dimension – the possibility of losing capital values for which the proxy is typically volatility and possibly maximum drawdown. But risk has more than one dimension, especially when it comes to taking capital and income from a pension or other portfolio to fund annual expenditure. Many clients find it hard to understand that changes in the value of their capital will impact on changes in their future income.
Cashflow planning can demonstrate the likelihood of clients’ money running out at some point in the future, based on various scenarios and assumptions about investment returns. Clients may therefore get an indirect sense of the security of their future income, but not necessarily a clear idea.
Maybe the answer is for advisers to pay more attention to finding out about investors’ attitude to risk with regard to the security of their income – not just their capital.
Different incomes
Some income is more dependable and secure than others. In most respects the most satisfactory income my wife and I receive is from our two state pensions and her teacher’s pension.
Pretty much every other source of income feels (and actually is) less secure. Dividends feel reasonably dependable, or at least more regular than capital gains, but recent experience undermines investors’ faith in such ‘natural’ income. And, nowadays, safe cash and fixed-interest investments produce negligible income returns.
The one exception is the widely but perhaps wrongly despised annuity, where a client can swap a capital sum for a guaranteed lifetime income.
Do clients really get to consider the relative merits of a lifetime guaranteed income from an annuity in relation to the flexibility of pension fund withdrawals – at least as part of their strategy? With such an income underpin, clients can afford to take more risk and get potentially higher long-term returns from their other assets.
The choice between capital and income withdrawals, and guaranteed annuity payments, is similar to the decision whether to transfer from a defined benefit pension to a defined contribution pension – and should be considered as carefully. As the pandemic has reminded us, there is more than one dimension of risk.
Different dimensions
How I feel about my future income and capital does not easily fit into a uni-dimensional risk scale of one to 10, or even one to 100. It is far more complicated than that because there are several dimensions of investment risk – just as there are several dimensions of pandemic risk.
There is the risk of losing money I can probably afford to lose, but which would keep me awake at night if it looked as if I had lost it: psychological tolerance of risk. That might change with familiarity with investing, coaching from an adviser and happy experience.
Novelty, friends’ and relations’ doom-mongering, and some unfortunate investments could all tip it the other way. I am more relaxed about the pandemic now that I am used to it, but it might have been different if a family member or I had caught it.
There is also the risk of losing money I can’t afford to lose if I want to maintain a lifestyle I have decided is reasonable: ‘capacity for loss’, in compliance speak.
The peculiarity of financial planning at the moment is there are simple and widely used techniques for measuring risk tolerance and so they receive most attention when setting clients’ risk profiles, and therefore portfolios. There’s a danger that the more useful and critical capacity-for-loss discussions are given less importance.
Risk with investing is much like risk in a pandemic. It needs talking about and probably at some length; a questionnaire is just a starting point for discussions.
But of course we are now nearly half a year on from the start of the pandemic – in our house we have been locked down since early March – and we aren’t anything like as panicky as we were in the very earliest days when we carefully wiped down everything that came into the house from Ocado, Amazon and the Royal Mail. We know much more and we have simply got used to the possible threat, but of course we could be overconfident now.
There are so many types and dimensions of risk, and different ways to experience and assess it. What’s more, our circumstances and our perception of them do not stand still, especially now. So talking about risk with clients should be a continuing dialogue around change.
Danby Bloch is chairman of Helm Godfrey and head of editorial strategy at Platforum