Many years ago, Nabisco, the biscuit manufacturer, developed an advertising campaign around the concept of people engaging in dangerous acts for the sole reason of consuming its wheat-based cracker called Triscuit. The slogan “Risk it for the Triscuit” became American slang for taking extreme risks for little reward.
Risk and reward is a financial planning concept which many people struggle with. Just because something is possible doesn’t necessary mean it is probable. And even if something is probable it doesn’t mean that it is particularly relevant.
For example, say I want to cross the road. If I choose to cross a road with very little traffic, during the day, at a clearly marked pedestrian crossing and I look and listen carefully, the chances of me being involved in an accident are extremely low.
On the other hand, if I choose to cross a very busy road, at night, while listening to music and looking at my smartphone, the chances of me being involved in an accident increase significantly. That being said, an accident isn’t inevitable.
Taking the higher risk is all well and good but it only makes sense if the reward is high enough to compensate.
In both cases, the reward I get is the same — I cross the road. But what about if the risky crossing helps me avoid a three-mile walk to the pedestrian crossing and means I can watch the recording of an important business meeting so I can be prepared for my next meeting?
In financial planning, risk means the likelihood of failing to meet your lifestyle spending and other important goals. The reward means that you are better off financially than had you not taken the risk.
You should only take those risks which you need to take and which have a high chance of being compensated in the form of a better financial outcome.
Many people take risks they don’t need to take. For example, investing in risky stock market investments in old age as part of an inheritance tax planning scheme. Or giving up a valuable defined benefit pension which would be sufficient to fund core lifestyle spending.
But some people don’t take enough risk and as a result don’t always live the lifestyle that they might.
A few years ago I reviewed a trust. It had been set up with £200,000 in 1982 to provide an income for the deceased’s widow and, after her death, the capital would revert to his sons from an earlier marriage. The trust was invested in a portfolio of high-yielding gilts as that provided the widow with the income she required.
Twenty-five years later, the trust was worth about £100,000, the income paid to the widow was about 25 per cent of what it had originally been after inflation, and the outlook was for the trust to be worthless within 10 years.
Had the trustees invested the capital in a more diversified portfolio including global equities, the widow would have started out with lower income but it would have grown in real terms to be many multiples of the starting amount and the capital would have been worth well over £1m.
Risk and returns are related. There are no low risk, high return investments. If you want higher returns then you must accept higher risk. The risk might mean the potential for total loss of capital, such as investing in a start-up business. Or it might mean the actual return might turn out to be within a wide range.
In the case of stockmarket investments it will mean that the value of your portfolio can rise and fall — sometimes by a wide margin — from one week to the next. As a very rough rule of thumb, stockmarkets are generally falling one-third of the time and recovering or rising two-thirds of the time.
Where taxation is a feature of an investment, it can mean not getting some or any of the anticipated tax benefits or treatment. Many investors in film schemes are finding out that this can end up costing them even more than they invested.
Active investment management is a source of significant risk for many investors — both individuals and institutions. This is because you pay a significantly higher annual management fee in return for the very low probability that the manager will deliver higher returns than the market.
The manager must deliver sufficient additional returns to cover both their fees and the additional investment risks that they have taken to achieve those returns. Remember, higher risk is the source of higher returns.
The empirical evidence shows that, net of fees, the chances of the investment manager delivering outperformance is extremely low. The chances of an outperforming manager repeating that performance is even lower.
The key question you need to ask yourself is this: do you need to take on the risk of underperforming the stockmarket in return for the remote possibility of outperforming it?
If you have confidence in an investment manager and you need higher returns than the market to achieve your goals, perhaps it might be worth the risk. For most people, however, stockmarket risk alone will be enough to achieve their life goals, by using low-cost index funds.
Remember, don’t confuse an investment manager’s need to justify their business model with what you need to achieve your financial goals.
The only way you can work out the risks you need to take, can afford to take and can psychologically cope with taking is to have a financial plan. Whether that is a simple retirement income plan or a comprehensive intergenerational estate plan, knowing the context is vital to making good financial decisions.
A few years ago I was counselling a newly retired married couple. I showed them that they would be financially secure under every conceivable scenario and that they could afford to live a bit before they got too old.
A key short-term goal was a six-week trip to Australia and New Zealand, which they were planning to fly economy-class. I tried to convince them to fly from London in business class, to have a better experience than 23 hours sitting in economy. They could easily afford it, but they just didn’t think they could, or should.
A few months later I received an email from the couple with a picture of them drinking champagne in business class on their flight to Australia. All the message said was “See, we did take your advice!”
Sometimes you do have to risk it for the triscuit.
Jason Butler is a personal finance expert and a former financial adviser. Twitter: @jbthewealthman
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