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When it comes to wealth creation are you your own worst enemy?

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Thursday February 28, 2013 at 9:00am

Probably one of the least well understood yet most important concepts for your future financial wellbeing is the concept of investment risk. When saving for the future, especially for retirement, everyone wants to maximise the return on their investment, yet not everyone has the same attitude to risk. Of course the greater likely return, the higher risk you will need to be prepared to take. Beware of anyone who suggests otherwise.

But risks is only part of the picture, it needs to be coupled with an understanding of the effect of compounding which has a hugely significant effect on the performance of an investment over time. Or to quote Albert Einstein “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t pays it.”

The compound annual return, otherwise expressed as the internal return on an investment over time is the only thing that matters in the long run. The higher it is the earlier people can retire, the sooner they achieve financial independence and the easier they can sleep at night.

Investment risk is defined as the risk that an investment’s actual return will be different from what was expected. A mathematical way of expressing this is in the standard deviation of the average returns from the mean return. The higher the standard deviation the greater the risk. In other words a high risk investment is expected to give a higher return over time but the journey will be full of ups and downs and it is especially these falls in investment value that spook people for purely psychological reasons. Indeed Daniel Kahneman, a psychologist, won the Nobel Prize in Economics in 2002 for his work in this area.

The psychology of investing

So, the question of how a psychologist can win a Nobel Prize in Economics is answered by the fact that investor emotion goes a long way to dictating behaviour and hence long run investment returns.

I went to a talk recently by Dr Greg Davies who is head of behavioural finance at Barclays. He was talking about anxiety adjusted returns whereby investors suffer discomfort now in terms of their new investment potentially falling in value, in return for higher returns over the long term.

This is expressed in the emotional roller coaster ride people take when they make an investment. As the value increases their emotional state moves from optimism to excitement and then to exuberance. As it falls their emotion turns to denial, they probably stop logging on to see the value at this point. The cycle then moves to desperation, pain, capitulation, depression and then when the value starts to rise, the emotion moves from apathy to indifference, reluctance and back to optimism.

When looked at this way the real risk of holding a volatile (and so high risk) investment is that it will have fallen in value at the point that the investment is needed. As properly diversified investments do increase over time then the time an investment is held is more important that the underlying volatility or risk.

Taking the emotion out of investing

So, perhaps the real lesson in investing is:

  • Hold a properly diversified portfolio with sufficient non-volatile fixed interest to match your anxiety adjusted returns
  • Rebalance each year, which will bring the original equity versus fixed interest proportions back to the original holding. If you think about it this behaviour effectively forces you to sell high and buy low.
  • Ensure you have the right volatility until the time you will need the money. In other words if you are saving for a holiday next year you should not invest in equities as they are too volatile over such a short time period and they may have fallen in value at the time you need to pay for the holiday. However, if you are investing for retirement you can and probably should have a much higher equity content as you will not expect to access the investment until you retire which may be many years away.

To take the emotion out of investment and financial planning decisions it pays to have a full review of your financial situation and prepare a proper financial plan. The discipline involved will help to clarify short and long term goals which will allow you to have an investment plan designed to meet these goals.

Andy Parker
Financial Advisor and Chartered Financial Planner

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