In this longer than usual article, I will explain with some examples why the rather crude processes used by many advisers to decide how much risk they should propose you take when investing your money will pose more questions than they answer and how what may seem to be “common sense” might be anything but. This is a crucial topic because your happiness depends on your portfolio behaving in line with your expectations!
Questionnaires
Most financial advisers and investment web sites offer some explanation of risk and quite a few offer questionnaires and on-line tools to help investors work out how much risk they want to take. This sort of process is a formal requirement for regulated financial advisers in the UK. But do the processes commonly used work well for investors?
Feedback I received from well educated clients, some of whom worked in industries where risk was always a consideration – like oil refining – was that the sort of questionnaires I was sending them were rather elementary and at times downright silly.
Over time I and my colleagues developed better questionnaires and they were designed more to make people think and stimulate discussions than to deliver a convenient point on a scale that told me how to build an investment portfolio. I read extensively around the subject and discovered how psychologists measure people’s behavior, learning a great deal about why my clients reacted as they did to the changes in their portfolio values that followed stock market cycles and events.
Capacity for loss
The UK regulator also expects people to have a discussion with an adviser about capacity for loss. What does that mean? It is a judgement about the impact of losing some or all of the money that is being invested on the lifestyle of the investor. For example, a simple questionnaire might suggest that as a personality, someone is very cautious and would not take any risks with their money.
But if this investor had millions in bank deposits and was the beneficiary of a family trust fund that would provide all her income needs for life, her capacity for loss when investing £300 a month into a personal pension from age 35 would be very high. If the pension fund failed to even return the money she saved over 25 years, it would not make much difference to her financially. She could lose the lot and hardly notice.
This example is perhaps rather unusual but it raises important questions. All experienced investment advisers will know that investing a monthly amount very cautiously over 25 years is extremely likely to result in a much smaller final pot of money than investing adventurously at first and then later on gradually consolidating the investment into different less risky assets. However, if their file includes records of a discussion and documents such that the client comes over as very cautious, how can they make what is very likely to be a sensible recommendation to take more risk?
How things go wrong
There are other obvious problems with the simplistic assessment of people’s attitude to risk. Many investment advice firms use a fairly crude process to directly transfer the results of a risk attitude questionnaire (that may have very little value in the opinion of a qualified psychologist) into the selection of an investment model.
For example, Mr X gets a score of 5/10 after completing a risk form, so he gets the adviser firm’s ready made level 5 portfolio and possibly keeps it forever. In the worst-case scenario, this will be irrespective of his objective in investing! So a person who is 30 and saving for retirement gets the very same portfolio as someone who is 65 and wants a pension drawdown plan. It really happens and that is very unsatisfactory.
Of course, a more professional and intelligent adviser will be more sophisticated. They will take account of the likely investment time period, the investor’s access to other assets and various other factors. An important one is the need to have income.
This requirement is worth exploring a little further in this introduction so as to demonstrate the way in which assumptions about what might be risky and what might be safer can be simplistic and downright dangerous.
All may not be what you think
I often see people getting poor advice about how to take an income and they really are given no chance of understanding why it is wrong. Many people have been told, probably from back into the 18th century, that you can spend income from their investments but you should never touch the capital. In a particular, now rare, financial climate, where there is no inflation and high real interest rates, that is good advice but extending that maxim to stock market investing can lead to serious disappointment.
Many advisers will supply a specific “income” portfolio because their clients say that is what they want. The adviser will often say it is less risky and indeed assets that pay a high yield (interest, dividends or rent) are at least theoretically less volatile because as long as the income is likely to continue, such assets are likely to always be in demand. However, that is once again an overly simplistic approach. Why? Because of the way investment markets work. Let us look at what happens in the real world.
If an investment management business wants to attract money to its investment funds so as to collect plenty of fees, it will try to make them look competitive and better than the other funds in the market. Business is business in the investment word, just the same as elsewhere.
Knowing that human beings are mostly folk who don’t like thinking too hard (read the excellent book “Thinking Fast and Slow” by Daniel Kahneman if you want to check that assertion out), the marketing team at the investment house may well ask a fund manager to run a fund with an attractive income yield.
Publishing that yield will attract investors and for that matter less well qualified advisers, who are not thinking to hard, or even just don’t get enough information. The fund managers may even have done research to see what advisers (who will in effect be selling their funds) think investors would like to have and try to get the fund paying that yield.
Most fund managers are well qualified, clever people with a very good knowledge of the markets they invest in. They get well paid as a result. They get bigger bonuses if their funds get bigger because their employer is getting in more fees, fees being a percentage of the fund. Unsurprisingly, they tend to co-operate with the marketing teams in their firm. They can get a bigger yield in plenty of ways, but some of those techniques, for example using derivatives, will increase risk.
Nearly all methods for getting more income will result in less potential for capital growth. That may not be exactly what the investor thinks they are getting. In my experience, most investors who are given an income portfolio by an adviser assume their capital is “safe”.
Deeper questions
There are a huge number of ways of delivering an income from a portfolio, so the above is just an example to introduce the idea that what might start off looking like lower risk can actually be rather different. Let’s look at another real world scenario.
Imagine that you invest your money in a diversified portfolio and your adviser says some of your funds will be sold every month to give you your income. Growth in the fund should over time put back the money. Sounds fine? This adviser is obviously thinking about total returns, which sounds better.
What if the stock market falls sharply? That is bound to happen at some stage. To give you your income at a fixed level, you will have to sell more and more units in your funds (or shares), because they are going down in value. That means those units won’t be there when the market recovers.
Say the market fell 40% and so did your portfolio without any income being paid out. The residual base of 60% will need to rise 66.6% in a market recovery to get you back to where you started. That is challenging but imagine that the decline was during a recession that lasted 3 years and over that time you sold 15% (in money terms) of your original fund to pay your annual 5% income (3 times 5 equaling 15). But the units you own, as the recession progressed, were going down in value so you had to sell more. In fact, you cashed in units worth 20% of your starting fund.
Your base capital at the end of 3 years might only be 40% of what you started with! That would require a market recovery of 150% and a period of no further income to get you back to where you started. A disaster. I have seen exactly such disasters in the past.
The really good adviser will point out that the best way to control risk when drawing money from your investments is to think about the fact that if you are spending some of your money, you ought to know what is being given up to supply the cash. It could be that you are selling investments at exactly the time you should not be or it could be you are taking income from high yield funds that will be subject to large capital losses.
It might be you are withdrawing pure income, but it might also be capital depreciation, perhaps in the future. Harder to grasp might be the fact that the high income reflects a poor business model that is about to backfire – banks paid very high dividends before the 2008 financial crisis. Furthermore, if a company has been paying a high dividend, so that is has been chosen to be in your high income investment fund, but things start going wrong, so the dividend is cut, the market will lower the share price almost instantly. That will not be positive for the capital value of your investment.
Real ale or lager?
It is often very good practice to think of financial planning not just as a start point and a desired end point but as a series of cash flows over many years, varying to meet your needs, both out (savings and investment) and in (income and capital gains taken).
The key risk management point when considering taking an income from a portfolio is to always take the income from cash funds, not by constantly selling investments. It makes sense to raise the cash when the time is right, even if you don’t need it immediately. Selling when markets do well and living on your reserves when markets are falling is a very sensible approach. The investments that pay income anyway (like property funds) will deliver useful cash flows as well but this will be incidental, not the driving force for the portfolio design. Incidentally, in many cases, that approach will result in less tax being paid.
I have often said to clients that when they want to spend money, they ought to imagine themselves as drinking beer (or any beverage of your choice that you can’t get for free). You would not get a pint of beer from the barrel in the pub cellar yourself.
You would certainly not go to the brewery and ask for it from the copper vat. You would ask the bar staff for a pint and assume they have worried about the issue of having enough beer in the cellar (liquidity) and think about when they will place their next order for a delivery. You also assume that if there is world shortage of barley, you can let the brewery sort that out and all you might notice is that the price goes up a bit.
Thus it is with any investment proposition that you want to run to give you an income – for school fees, for a care home, for a pension and so on.
The money you take out every month (your pints) should not be coming from the brewery (your portfolio) but from the bars ready stock of liquidity (your cash deposits). The pub (your investment adviser) should be working out how to deliver beer (cash) to the bar, ideally at a good price, and the brewery (the investment fund managers) should be worrying about markets over the long term and stocking up enough barrels in their yard, so that if the factory has a breakdown (a stock market crash), you will just see a report in the paper, discuss it at the pub with your mates, worry a bit, and not in practice need to change your life at all.
And I could say a lot more….
This piece is meant to be a thought provoking introduction to a really big subject and I will post more analysis in smaller chunks in the blogs over time and add extra longer articles.