What is the risk in pensions & investments?
The way we deal with risk depends on how we define it.
I have considered writing this blog for some time as explaining risk can be challenging when advising clients -and stay with me because this one is a little long.
Below I will attempt to bring clarity on types of risk, risk managment strategies & how fear of perceived risk can hinder investment return. Skip the part on pension basics if you are already familiar.
First I’ll explain the basics of pensions/investments:
When paying into a pension or investment you are buying units of an investment fund. (unless you opt for direct property or stocks, which is rarely done) An investment fund could be made up of property, bonds, stock holdings or a combination of multiple asset classes -investment funds offer less risk than individual stock trading where the down turn of one company could cause severe losses.
The value of the fund’s units determine the value of your ‘pot’. When the value of the units fall, your pension/investment loses value, however, you still hold the same number of units and have not incurred a loss unless you sell while the units are low. When the unit value rises, the value of your pension/investment rises. With long term investments, you will see many ups and downs along the way. (scroll down to see a chart of actual fund returns over time in Ireland)
Investment firms use various metrics to attempt to categorise their investment funds by ‘risk’ tiers from low to high. Advisors match clients with the appropriate investment fund using risk tiers dependent on client goals and circumstances. Over the years, you will likely need to change your investment fund to keep risk in line with your circumstances.
What should I consider?
Discussing and assessing risk is a necessary part of finanical planning but the use of ‘risk tiers’ is an oversimplistic model, that can be off putting to many, resulting in poor planning.
When considering how much risk one should take in their pension/investment, the two main considerations that should be made are ‘time horizon’ (the amount of time one will be invested) and diversification.
Time Horizon:
The market as a whole is cyclical and corrects itself upwardly trending. If you are investing for more than 5 years, history shows you have little chance of incurring a loss in the markets. The key is to refrain from panic and moving your funds while they’re down -compare it to selling your home in a housing downturn, you would wait until your home’s value returns before selling (unless you had no other choice), the same should be considered when investing. If you are within 5 years of retiring, you then look to reduce your risk as appropriate so you are not forced to sell (encash) during a downturn.
Diversification:
This is a term most people will be familiar with but may not understand how to attain. When investing, you want diversity of asset classes (equities, bonds, alternatives, cash), country/geographical area, and sector (tech, energy, healthcare). Multi-asset funds allow you to have diversification handled within one fund with fund managers investing in various asset classes, adjusting holdings within the fund as appropriate. Or you could opt to invest your contributions in a handful of different funds to acheive diversification.
Other risks to consider:
Timing Risk: Markets move up and down frequently. One way to mitigate timing risk is to make regular contributions in leau of annual lump sums or to trickle a large lump sum in through monthly payments over a 1 or two year period.
Liquidity Risk: does the fund have the ability to place a moretorium on your monies, (a time which you cannot move your funds) or are you investing in property that will need to be sold before you have access?
Sector Risk: are you investing in a specific sector, such as technology or engergy where your entire investment relies on the trajectory of that industry?
Country/Geographical Risk: Are you heavily invested in bonds, or equities within one country or geographical location?
Funds are typically rated on a scale of 1-7, low to high risk. Here is why these tiers can be misleading:
A tech sector fund may be given the same risk rating as multi asset fund with a high level of equitities: The multi asset fund will be diversified in asset class and sector (and likely have diverse geographical holdings) while the tech sector fund will not offer diversity of assets, or sector AND likely be concentrated in North America. Another example is a property fund could be considered a medium risk fund but offer no diversity of assets and come with liquidity risk.
This does not mean one should not invest in technology or property funds; just be mindful that if you want to invest in a particular sector, be sure to have other holdings (and not put ‘all of your eggs in one basket’).
Being overly risk adverse can be costly.
If you invest in low risk funds, history shows that over the long run, you will have lower returns than your peer who invested the exaact same amount in higher risk funds.
Below is a chart showing the real performance of Zurich’s cash fund, Zurich’s Prisma 2 fund and Zurich’s Prisma 5 fund from 2013 to March 2021. I kept the funds with one provider to accurately show the difference between risk ratings & performance.
Cash fund to represent no risk, such as holding funds on deposit, the Prisma 2 fund is a multi-asset fund rated a 2 out of 7 and the Prisma 5 fund is a multi asset fund rated 5 out of 7. (Both the Prisma 2 & 5 have the ability to flucuate up to a risk 3 or 6 respectively.)
While the Prisma 5 fund has far more volatility and incurs many ups and downs along the way, you will see it consistently recovers quickly and provides a strong return for investors.
If one were to ‘play it careful’ and opt for Prima 2 for a long term investment they will have missed out on the opportunity to have a substantially bigger pot at retirement/encashment. (This is key, often people who do not have investment experience are in low risk funds because they have not been given proper advice.)
And if you invest in cash you simply lose value. Cash should be a placeholding fund only, for use temporarily before encashing.
I hope this helps you better understand what risks you are taking within your pension/investments. Questions?? Talk with your advisor or contact me anytime.
And please do not be afraid to start investing in your future because of the word risk.
Author: Rachel O’ Shea, QFA, Senior Consultant & Protection Manager