When we put money in our pension, we’re investing it with the intention that it’s going to be worth more in the future. The level of risk that you take today will depend on how much more that’s worth. There’s potentially a significant variance to people’s wealth if they over- or underestimate the tolerance for risk over a long investment period.
We caught up on a conversation between Feargal McKenna, head of corporate at online financial advisor Moneycube.ie, and Judith Casey, investment marketing specialist at Standard Life.
This article is an edited extract of a webinar on consolidating your pension held as part of PAW21.
Feargal McKenna, Moneycube: When it comes to investing, there’s lots of decisions like, how much should I invest? Should I get help? What asset class should I put my money in? Which fund should I put in?
And then there’s the paperwork, and one of the pieces of paperwork you’ll be asked to complete is a risk assessment questionnaire.
By the time you get to the paperwork, it’s natural enough to be a bit fatigued with the process and as possible, the conversation on risk may not have been given the attention it deserves. And, for example, just because you like to take risks from a day-to-day perspective in sports or hobbies, doesn’t mean you do or should take risks with your investments. Or alternatively you may be a risk-averse person in life, but you may have a tolerance for taking risks in investments. The results of a risk assessment could have a material impact on return, particularly over an investment in something longer such as your pension and that’s likely to be the longest investment horizon for most people. Knowing your own attitude to risk and checking if you if your investments match is vital.
I’m delighted to be joined today by Judith Casey who works in investment solutions at Standard Life to discuss the topic.
So I guess first of all Judith, what exactly do we mean when we refer to risk?
Judith Casey, Standard Life: Thanks for that introduction Feargal
There are a couple of different types of risks. When it comes to investing this includes inflation risk, market risk, currency risk, but in general terms, investment risk is a probability of incurring losses, relative to the expected return on the money you put into your investments.
Different types of investments carry varying degrees of risk. So when you’re deciding on what to invest in, you first have to consider what level of risk you’re happy with, or what’s your risk tolerance, which is a measure of your emotional response to changes in the value of your investment.
Everyone has different risk tolerance. The important thing to remember is every investment carries some degree of risk. And the key is to find out what degree of risk are you comfortable with and this is where your financial advisor can assist.
It’s worth saying as well that there’s a difference between volatility and permanent loss of capital and these are routinely confused you know
There’s an element of inevitability with volatility, but permanent loss of capital would only occur when that volatility is in the negative. So volatility in itself is not the bad guy here. It really only impacts people’s investments if there’s too much volatility in a shorter timeframe.
And it’s probably worth mentioning as well, that it’s not just a case of just taking more risk. If you get greedy and end up taking too much risk outside your tolerance levels, chances are, you might panic and end up selling it at the wrong time.
FMcK: So with that in mind, the industry has a way of measuring risk. Could you talk us through that?
JC: Well, the industry regulators has created an investment risk categorization for investment funds, and these are known as the ESMA volatility rating.
When it comes to markets, we cannot see how investments will perform in the future. The only thing we do know is how a fund is performing the past. So as one looks back over the past five years performance of the funds and calculates the investments ups and downs, one can measure how volatile the fund was during a period. In ESMA, 1 is ranked as the lowest risk and 7 would be the highest.
So, for example, an investment with ESMA 1 rating, might be a cash fund, an ESMA 4 would be maybe a mix between equities and bonds, and an ESMA 6 might be a fund investing only and equities in a particular region such as China. But just to caution here that considering ESMA alone can be misleading, and ESMA does not tell you about the maximum drawdown.
FMcK: Okay, and maximum drawdown: that’s another one of those financial services buzzwords. Yes. Could you explain what you mean by that?
JC: Maximum drawdown calculates the difference between a fund’s highest value and its lowest value and it’s basically the unluckiest possible investor in the fund. So the investor who bought at the very peak and sold it when the fund was at the bottom. So it’s really important to consider max drawdown also as well as the ESMA ratings.
FMcK: Okay, so that’s the that’s the way the industry categorises risk. There’s a way people can find out about what their own attitude to risk is.
JC: Sure, yeah. If you’re sitting down with a financial advisor, he or she will assess your current financial circumstances and look at your assets, liabilities, your investment needs and your financial goals. And there’s also a risk questionnaire which helps you to determine your risk tolerance. So, again, the industry and regulators have issued guidance. That means most financial advisors will provide you with the risk questionnaire or you can do it on your own.
These are generally a set of questions and how you answer these questions will reveal your attitude or capacity for risk. So I’ve seen many people completing our risk questionnaire thinking, yes, I’m a risk taker, but when it comes to investing for their pension, or investing for the kids’ school or college fees, they may not be so risky. And it’s interesting to see the differences now in risk appetite when a couple complete a questionnaire together. Often the results can be very different.
I don’t know if you watch the cliff diving in the recent Red Bull competition at Downpatrick Head. So cliff diving is no doubt a very risky sport, but just because a participant is a risk taker for sport doesn’t mean she’s a risk taker when it comes to investing. So she could be very cautious when it comes to investing or for a future.
And the same can be said for anyone: lawyers, accountants or actuaries. Therapists seem to be very conservative in their profession. But when it comes to their personal investments, they may be more savvy and perceive taking on more risks to be the right course for them.
Generally, we see people having three buckets when it comes to their money and each bucket would have a different level of risk. So if you look at your day-to-day expenses bucket, you’d have no risk at all for this focus. And if you look at a 12-month focus, this will be current expenditure that you’d have on an annual basis such as your car insurance, your holidays. You probably don’t want to take too much risk with this focus. But when it comes to your long-term financial plans, your goals and you can afford to take a lot more risk with this. Investing for a pension can be for the longer term. So generally you take a bit more risk. If you’re starting to save your pension in your 50s you might not want to take as much risk but if you’re starting in your 30s you can take a lot more risk with that.
And I guess your attitude to risk is recorded at a at a point in time and it reflects your view of life at that point in time, your emotional states. The timeline of investments that spoke about and I guess how financially comfortable you are, and these things change, right? I mean, the change the world has changed for everyone in the last couple of years. And I’m sure that people’s perception of risk has changed in that in that timeframe.
And I suppose that leaving aside the changing factors in your own life as we get older and get more experience with investing, learn more about it, our attitude to risk probably changes as well. There’s this common thought that investing is risky, but when you get into it, there are elements of it that you can invest in a low-risk way. So I think that with time there’s probably a better appreciation of risk.
And I’d say as well, the criteria to test the tolerance for risk is probably moved on and probably getting a bit more sophisticated as technology comes into play. So there are many ways that you can assess your risk and lots of different questionnaires out there.
FMcK: What’s the one that standard life would stand by?
JC: The one we use here is centred life and is with aura which are Oxford Risk research analysis company. So basically, there are a series of questions which are designed to calculate your tolerance to risk and as I said, this is a measure to your emotional responses to changes in the value of your investments. So there’s 17 questions in all and they assess five different risk measures.
There’s perception. How you perceive your risk behaviour, you risk versus reward. How would you view the trade-off between risk and return.
There are future-looking questions concerning whether you’re likely to be more or less risk-tolerant in the future.
There are time-based questions. Are you investing for shorter or longer term?
It’s good practice we believe to review this questionnaire when there are significant life changes such as when the mortgage is paid off, and when you do not have to pay college fees anymore, or when you’re retiring. All these changes would impact your attitude to risk and you may wish to take more or less risk. And it’s important to bear in mind, you know, those types of questionnaires that you know, they should be used as the guide and your financial advisor will help guide you as to what the right investment is for your risk level.
FMcK: And I think in the past, these have just been kind of paper-based questionnaires and not too much attention is paid to them. But I guess the technology is getting better and Standard Life have an online questionnaire which can be filled out.
JC: Yes, anyone can look online to assess their risk category and why.
There are a couple of points to bear in mind when you do. One would that you could be taking a risk by deciding not to invest. While most investments involve a degree of risk, it’s important to realise that even deciding not to invest could explode into risk. Your capital could be stolen or spending power could be reduced by the increased price of goods and services. That’s inflation risk. So from our earlier example, if you’re investing for a significant amount of time, you could be taking a risk by not taking on more risk in your investments, which we just discussed there for customers coming up to their retirement.
The second thing I just want to reiterate is manage your expectations. People often underestimate the amount of capital required for their pension, what you invest is really important when it comes to saving for your retirement: it can’t all come from investment growth.
My third point is diversify your investment. First this means spreading your money over several investments. You’ve all heard the saying to avoid putting all your eggs in one basket. It makes sense because it will reduce your dependency on one course of action. As you’ll be effectively spreading the risks you are exposing your investment to so this can be achieved by investing in different types of assets, industry sectors and geographical regions.
Fourthly, balance and rebalance your portfolio. As a general rule you should reduce your exposure to risk as you get older. As time goes on your personal circumstances and market conditions will change this likely to impact on your investments. So rebalancing your portfolio means that you need to review your investment to make sure that it’s still suitable for your current needs.
And finally, know your attitude to risk. Look at your existing investments, take a risk questionnaire, and ask: do your current investments match your attitude to risks and talk to a financial advisor who can help.
FMcK: At Pensions Awareness Week, we’re all about action. So if we’re to apply what we spoke about today to your real-world finances: it could be that your circumstances have changed. You’d like to take a higher or lower risk level than when you first invested.
You might have started a family. Or as you’re getting closer to retirement your capacity to absorb financial volatility has changed. And you might have better visibility of the goal that you have for your retirement pot.
Taking action today can bring peace of mind by knowing that you’re on track with where you want to be or whether your investments are matched to your attitude to risk.