Understanding investment risk is not just about assessing different asset classes. It is about taking a holistic view - one that incorporates your personal circumstances, your temperament, and the nature of the investments themselves.
To truly see investment risk clearly, think of it as combining three primary colours of light: red, green, and blue. When these colours come together at full intensity, they produce white light, allowing for a clear vision.
For us:
• Red represents your stage of life.
• Green signifies your temperament.
• Blue corresponds to the three primary asset classes: cash, bonds, and equities.
The Traditional View of Investment Risk
When people discuss investment risk, they typically focus on the characteristics of asset classes:
• Cash is perceived as safe - its value remains stable, but it loses purchasing power over time due to inflation.
• Bonds are seen as a middle ground, offering relatively stable returns but still carrying some risk.
• Equities (shares) are considered risky because their values fluctuate significantly, though they tend to provide higher returns over the long term.
This classification is based on the standard deviation of returns - how much their values fluctuate over time. However, making investment decisions solely based on asset characteristics is a mistake.
Two additional elements are equally important: your temperament and your stage of life.
The Importance of Stage of Life
Your age and financial situation dramatically alter the risk profile of investments.
• In Your 20s: If you are young, working, and have few financial commitments, holding large amounts of cash can be hugely risky.
Inflation will steadily erode its value, making you poorer in real terms over time.
Conversely, investing in equities - despite their volatility - can be less risky for you because you have time to ride out market fluctuations.
Regularly investing in shares allows you to build long-term wealth.
• In Your 60s and Beyond: If you are retired or close to it, relying solely on equities might be too risky.
You may need a portion of your portfolio in cash for immediate expenses and bonds for stability.
While equities can still play a role in keeping pace with inflation, your short-term needs should take priority. The goal is to create a buffer against market downturns while maintaining a steady income stream.
The Role of Temperament
Your temperament - how you emotionally react to market fluctuations also plays a crucial role in determining risk.
• If you panic and sell investments when markets decline, equities might be riskier for you than their statistical risk suggests.
• If you chase short-term trends, jump in and out of investments, or follow speculative fads, you increase your own risk.
• If you remain disciplined, invest steadily, and diversify across a broad range of companies, you significantly reduce risk over time.
A good analogy is a razor blade: a Gillette Mach 3 is perfectly safe in the hands of a 50-year-old but could be dangerous in the hands of a 5-year-old.
The same is true for investments - the risk level depends on who is holding them and how they behave.
A Shift in Perspective: The True Focus of Risk Management
Many investors focus solely on how different assets behave, but this is misplaced attention.
Cash, bonds, and equities have well-documented historical performance and will continue behaving in line with their characteristics.
The real work should be on understanding your stage of life and your temperament - these account for at least two-thirds of successful investing.
By integrating these factors into your decision-making, you gain a truly clear view of investment risk and can make smarter, more personalised financial choices.