Why it’s important to weigh up investment risks

This article was originally published in The Telegraph

A couple of good friends took me out for lunch last week to pick my brains. With their kids tentatively moving off the payroll, they had taken the impressively bold decision to swap their house in London for a lock up and leave flat so they could go off and decide who they really wanted to be.

As a consequence, they now have £500,000 burning a hole in their pockets, jobs they can do remotely to fund regular additions to that pot, and a belated realisation that they might not have done all they could have over the past 30 years to set themselves up for retirement. Unhelpfully, I said that in an ideal world they’d wind the clock back a few years, but I reassured them that it’s actually not a bad place to be starting from.

I’m not a financial adviser so I got my excuses in early and pointed them towards someone better qualified than me. But I did earn my lunch by asking a couple of important questions: how long did they think it would be before they might want to access their money; and how upset would they be if their savings fell in value, temporarily or, in the worst case, more permanently when they came to cash in their chips? About ten years and pretty miffed were the fairly predictable answers - in fact, they told me, they had a target of doubling their pot over the next decade.

The rule of 72 tells us that doubling your money in ten years requires an annualised return of 7.2%. Given that they also plan to throw in a reasonably significant sum out of their income over that period, I don’t think their plan is unrealistic. But one thing concerned me. Ten years is long enough to make investing in risky assets like shares sensible but short enough for things not to work out as they hoped if markets don’t play ball. I wanted to put some better numbers on the chance of them meeting their goal, so I went away and consulted the Credit Suisse Global Investment Returns Yearbook.

The reason I asked my friends about their time horizon was simple. The dispersion of returns from stock market investments is significantly impacted by their time horizon, according to the Credit Suisse study. The shorter your time in the market the wider the range and the less predictable the outcome. The longer you stick it out, the more the range narrows and, crucially, the return you can expect gravitates towards a healthily positive number.

The best single year returns in the US stock market, even adjusted for inflation, have been nearly 60%, while the worst one-year falls have been in excess of 40%. But over a lifetime of investing, say 40 years, the range has narrowed to between about 4% and 10% a year. What matters for my friends is that over a ten-year period the range is still relatively high, at between about minus 5% and plus 15% a year. That’s why I said that in an ideal world they’d go back in time. There’s no substitute for getting on with it. Tell your children.

By the way, the dramatic dispersion of returns works at the individual stock level too. I looked this week at the one-year performance of the constituent companies in the FTSE 100 and was amazed at the range of returns. In a 12-month period that has seen the FTSE 100 go nowhere (up 1.8%), 29 of the 100 shares have risen by more than 20% while 10 have fallen by the same margin. Seven shares have risen by 50% or more, including two (Melrose and M&S) which have more than doubled, and one (Rolls Royce) the value of which has trebled.

The second question, about how my friends would feel if they lost money, temporarily or more permanently, is partly answered by the Yearbook’s analysis of drawdowns and subsequent time to recovery. If you are really unlucky, the market can fall far and fast. After the 1929 Wall Street crash, the US market fell to a trough in 1932 that was 79% below the peak. Getting back to square one took more than 15 years then, until nearly the end of the Second World War. This was an extreme period, but recovery from the 1970s oil shock also took more than 10 years in real terms and it was five years before investors had recovered their inflation-adjusted wealth after the financial crisis in 2008.

So, how can my friends avoid the risk, albeit slim, of being disappointed in ten years’ time? The most important way is to be well diversified. The 60:40 blend of shares and bonds got a bad press last year when it failed to deliver the smoother ride it promises. But in the long run the expected reward adjusted for volatility (what stats geeks know as the Sharpe ratio) is better than for either equities or bonds on their own.

The same is true of geographical diversification. Although globalisation has increased the tendency for markets to move in tandem, there is still a measurable benefit from spreading your investments around the world.

As we poured our coffees, I made one final point. With interest rates at today’s relatively elevated levels, my friends might realistically achieve their goal at almost no risk with a money market fund combined with a high enough level of additional contributions out of their income. Which begged my last question to them: how would they feel if they had adopted this cautious approach for ten years only to realise that the stock market had rewarded risk takers with even higher returns that they had missed out on? It’s a first world problem, but FOMO is just as real as fear of loss.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Please be aware that past performance is not a reliable guide indicator of future returns. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.