Michael Musing on risk

personal risk - photo source deshow.net

We all have different ideas of what constitutes an acceptable level of risk. This makes “risk” a highly personal measure (image source: deshow.net)

Risk is a difficult thing to measure, and no amount of study, research, experience or knowledge is going to make the measure of risk simple. It may be possible to use all that know-how to moderate risk but that doesn’t really help to make it simple or easy. Post the Global Financial Crisis (“GFC”), risk management for the vast bulk of humanity with enough money to be lucky to have the worry, has revolved around placing more money into cash and trying to moderate the low income cash pays by searching for higher yielding term deposits. Anything more than that and any pretense of safety evaporates. How has “group” thinking of “risk” changed now that we have had around 5 years of this financial turmoil and uncertainty?

Musing on Risk

Firstly, we should identify the core truth that risk is a subjective word. It’s meaning is different for each person, and the same person will have different views on risk throughout their lifetime. Academically, it is suggested that a person’s risk “profile” won’t change all that much over time. Subjectively, my experience is that the same person can display a wide range of risk acceptance/denial over a relatively short time.

Why is it important to identify definitions and understanding of risk over time periods?

It is important because a financial adviser is required to help a client keep their portfolio in such a way that it reflects, among other things, the “risk profile” (or tolerance or aversion) for that particular client.

So you can see the problem… If “risk aversion” as measured through a risk profile analysis, changes through time then how is a long term portfolio to be kept aligned with that change?

personal risk measures incorporate any number of variables

We all have worry at some level. How does or should that worry impact our long term decision making on money?

Here’s the classic post-GFC example…

Mary Constant has a good understanding of how money works. Her father built up a portfolio of “blue-chip” shares over his lifetime, and Mary had inherited them when he passed away. Mary is intelligent and capable, and took the time to educate herself on money and investments to gain a greater understanding of her investment decisions. Mary’s work income was stable, and she has always been careful with money –  making sure that she lives within her means. Mary met with an adviser who assessed Mary as having a risk profile that would cope with the voltility of higher share and property exposures. Accordingly, Mary increased the amount of her super and investments exposed to shares and property in 2000. As Mary held Australian shares in her own name, her super accounts had a greater exposure to international investments, as form of portfolio balance. When looking at her total portfolio assets, Mary’s money would look similar to the way a “growth” super fund is invested.

Mary worked hard, put in extra study and received ongoing pay rises, which she directed towards higher super contributions.

The GFC struck, and Mary’s super took a substantial hit to its value. Mary continued to pay money to her super, hoping to accumulate more assets at the lower prices. However, 2 years later the super account value was still less than she had paid in. Mary began to question the value of taking a more aggressive stance. Newspapers and internet articles were suggesting that the global economy would be headed into a substantial and severe recession. Others were calling it a depression. Mary met with her advisor regularly, and even though she could still answer the risk assessment questions in such a way that her “risk profile” showed up as “growth oriented”, the continuous calls of economic danger signs were causing her to worry about money, when she had never really lost sleep over money before. Mary understood that her emotions were beginning to push around her logic but when faced with review after review that showed a nil earnings rate, it was all simply becoming too much. Mary was getting scared of the possible investment outcomes. 

Four years after the GFC and Mary found that her account had not even been growing by the amount of money she was paying in. Mary sat down with her advisor, who pointed out that Mary’s higher contributions were tilted towards the more recent years, which meant that more of her money had been buying at recent prices. The advisor also pointed out that super contributions tax of 15% meant that not all of the contributions were actually available to boost the account balance. The advisor checked against other investment options and Mary’s were on par with what was happening elsewhere. None of this made Mary feel any better.

Mary’s own shares had initially rebounded well. Dividends were a lot lower of course but all of the companies had made it through the GFC so that was a good sign. Unfortunately, the value of the shares had fallen again, and they really hadn’t come close to getting back to where they were before the GFC. Mary decided to close her eyes and just let the economy turmoil play itself out.

“What are the super wealthy people doing?” Mary asked her advisor. Financial commentators were suggesting that wealthy people were more tactically flexible, and had access to a wider range of options than the average person. Some people were investing into hedge funds that offered a less volatile return. Private equity potentially offered a chance at higher returns. Mary switched some of her money into these, and started to carefully watch her cash, rotating it through various term deposits as rates changed over time.

Fees became an issue for Mary. Where she had only ever checked to make sure that any fees being proposed for an action were reasonable, Mary now felt a need to save as much on fees as possible. There seemed little point paying fees when no money was being made. Mary changed her super account to one with lower fees, and had her advisor keep track of the term deposit rates to ensure that she was earning as much as possible on her money.

Reputable public figures were calling the end of “buy and hold”. They were suggesting it was a strategy for fools, pushed on them by a lazy and corrupt financial industry. Some were suggesting “a storm was coming”, and that money had to be moved to cash to protect it from the global turmoil that was unravelling. At the least, there was little point sitting still, so getting more involved and more active with her shares, Mary bought and sold more than she had before, trying to maximise the utility of her own research and the recommendations of subscription services she had signed up for. Doing something was better than doing nothing, and Mary was determined to make every dollar count.

Come 2012, and the super fund annual statement shows that Mary’s returns are still no better than they would have been if she had simply stayed in cash all those years. Commentators are still suggesting the potential for recessions and global financial crises. Some were suggesting that Greece will be kicked out of the EU, and that China would struggle to keep its economy growing. That the USA was headed towards a “fiscal cliff” and that Australia’s reliance on commodities was about to hurt in a major way, as the commodity price “bubble” burst. Mary began to doubt the books and classes and advice that she had found or been given over the years, and considered moving her super account to cash, and try to get a higher return through term deposits, and reduce fees by setting up a self-managed super fund.

Mary has reached capitulation.

We all have a point at which we are too tired to fight. We give in. We capitulate.

We all have a point at which we are too tired to fight. We give in. We capitulate. But what then?

The need to “doing something”

It is easy to declare that the average human being in the middle of this turmoil is acting rationally when they start to adopt a shorter term result horizon, and act to “take control” of their money and outcomes. In fact, it would be foolish to watch a whole series of long-held paradigms dissolve into oblivion and to react by doing nothing. However, is it really rational to move your own personal outcomes into line with the pronouncements and recommendations of the current tv financial personality or a national investment newsletter, your neighbour or the wealthy plumber fixing your leaky taps?

In the example above, Mary has reacted in line with the bulk of the investment community. Cut costs, move to a more conservative mix of assets, trade your accounts more often to reduce the chances of large losses, and be ready to change your outlook quickly.

When super funds boast of returns of 5% over 10 years, it’s time to reassess just what is happening?

When residential property prices have not moved much for 5 years while the population has continued to grow, you’ve got to ask just what on earth is happening?

When commentators boast about staying in cash and avoiding all the turbulence of the past 5 years, you’ve got to ask yourself why seasoned investors and traders are content to bank an after inflation, after tax return of 0.9%. At that rate, it will take 77 years for your money to double. Is that a viable long term strategy?

It’s appropriate to do something but maybe there should be a little more thought on just what that “something” should be for each individual person?

Don't just stand there. Do something... But what are you to do?

Don’t just stand there. Do something… But what are you to do?

“Risk” is personal

Nothing has changed in this regard. The primary difference between wealthy investors and anyone else is that the wealthy investor is more likely to have a highly tailored set of assets. They would have paid the money required (even if it just meant leaving enough millions in a bank that you deserve a bit of extra attention)  to ensure that they have a risk profile in their assets that correctly reflects every nuance of their risk tolerance.

When financial turbulence hits world markets, “risk” starts to be discussed as something that is the same for everyone. Assets that previously were considered universally “safe” are now considered taboo, and short memories see people nodding their wise heads sagely while muttering “I told you so” or “it was so obvious at the time”. Everyone begins to doubt their earlier decisions, and the original objectives get forgotten. Individual risk profiles get subsumed into the “trend” of the moment, and when dealing with money, this is where the real risk lays.

Think it through. There was a big crash in sharemarkets from 2007 to 2009. At that point, there were still people calling for even larger falls in markets. Would you have been better off investing in March 2009 or should you still be in cash, waiting for stability to return to financial markets? It’s only a rhetorical question but we are already beginning to see fund managers and commentators return to their old ways, oblivious to the legacy of fallen markets and recovering investments that many people are still nursing in their portfolios. Everyone will have their own stories of losses or gains or understanding or the failure of understanding, and everyone will see that impact their personal risk tolerance differently.

Given that this website is free and free advice is worth the money that you pay for it, i’ll share with you my global risk profile and financial objective strategy for every human being on the planet.

I want to make money, cut costs and save tax without taking risks to do so.

Naturally, this is a non-solvable equation. You simply will not be able to do all of these things at the one time. Something, somewhere has to give.

Your risk profile is your personal assessment of the areas in which you have leeway, and the areas in which you do not, in your attempt to achieve a result as close as possible to that unachievable perfect outcome.


Leave a Reply