Usually when I sit down with a new client one of the first questions they ask me is what I think markets are going to do going forwards. In other words, they are asking what return they can expect on the money they invest.

Historically investors have been rewarded for taking on investment risk over the longer term as long as they are happy to accept periods of volatility. With this in mind, the question that I ask them is: how are you going to behave if markets suffer short-term volatility during your investment journey? Ultimately, the answer to this will decide how well an investor is rewarded.

The most successful investors almost always have an extremely disciplined approach centred on their investment philosophy. This usually requires a healthy acceptance of volatility and ensures that they stick to their investment process throughout all market conditions. This is of course easier said than done.

At Taylor Money, we look at three key factors to help a client understand how their willingness to accept investment risk can impact upon their portfolio over time. These factors are: time horizon, personal liquidity and temperament.

Time Horizon

The first, and most important, factor is an investor’s time horizon. For example, it would be ill-advised to sit in cash if you know you do not need access to the money for 30 years. This will almost always result in a loss in real value (after inflation) of a saver’s capital. As a financial cartoon once quipped:

‘The only way you can become a millionaire by investing in savings accounts, is to invest millions in savings accounts!’

Conversely, investing 100% in equities if you only have a time horizon of one week is equally rash. Over this time period the data shows that you have little more than a 50% chance of making money. This feels far more like Vegas than a measured investment strategy. When we stretch out the time horizon to ten years the probability of making money increases to more than 98%!1 Therefore, time horizon is the essential starting point and defining factor when deciding investment risk and asset allocation.

Personal Liquidity

The second factor is what we term a client’s personal liquidity. This encompasses a client’s cashflow, their ability to generate further capital in the future and their accessible capital. Having a high level of personal liquidity in times of emergency or when unexpected needs arise can help avoid accessing an investment portfolio during a time of market weakness. For this reason, a client’s personal liquidity is an essential factor when deciding how much capital a client should commit to long-term investment. Whilst it is not always possible to plan fully for unknown expenditure, leaving a healthy buffer in excess of known expenditure is a sensible starting point. Careful planning and working closely with an adviser will ensure the correct level of investment risk for your personal liquidity and time horizon

Temperament

The third factor, not to be overlooked, is a client’s temperament. Whilst the first two factors are the driving force behind decisions regarding investment risk, a client’s natural temperament towards investing must also be taken into account. Take two investors with identical personal liquidity and time horizons. The temperament of an investor who is naturally more risk-averse will lead them to taking lower investment risk than someone who is far more naturally accepting of it. A client who is risk-averse needs to understand the other risks to which they are potentially exposed by not accepting some measure of investment risk. For example, leaving monies on deposit over the long term merely swaps investment risk for inflation risk (eroding the real value of cash over time due to inflation in excess of deposit-based savings rates). Conversely a client whose adventurous temperament exceeds their level of personal liquidity or time horizon might need to be tempered to avoid taking on too much risk.

A client’s temperament is influenced not just by their personality but also by their previous experience or preconceptions of investing. Therefore, it is important we understand a client’s reasoning behind their underlying feelings towards investing. By doing this we are able to help educate and guide them into making appropriate decisions with their money.

With the above in mind, every investor will need to be treated individually with regard to how we position their portfolio. It is our job to educate you and, if necessary, challenge you to look wider than just your thoughts and feelings towards risk by considering the other factors at play when it comes to holistic financial planning.

Finally, to illustrate the importance of the three factors discussed in this article, take the imaginary example of Bob2.

Bob decides he is going to save £300 per month in cash however he is a nervous and unlucky investor, this means he only invests when markets have had a good run. He saves £5,000 before investing in the S&P 500 Index at its 1972 peak. Over the following two years he sees the value of his investment fall by 40% but continues to replenish his cash savings by £300 per month. It is then almost 15 years until Bob is comfortable to invest again, this time he has saved up £52,800 which he subsequently invests at the S&P 500’s peak of 1987. As before Bob’s investments are reduced by a stock market crash but he continues to hold his nerve by not selling and accumulate cash. Bob’s third investment into the S&P 500 comes at the peak of the 2000 stock market bubble where he invests his total monthly savings of £44,400. His fourth and final investment of £28,200 is then cut in half by the 2008 Financial Crisis.

Bob never sold his holdings and still holds the same portfolio today. So how did he get on?

What was Bob’s secret? Bob remained disciplined and held onto his portfolio, riding the market volatility because he had good personal liquidity and the correct time horizon for the investments he was making. No doubt at times his temperament threatened to let him down but the more he saw the benefits of long-term investment the easier holding on in times of volatility would have been.

It is fair to say that markets have been on a good run for the best part of eight years now. Bob’s example however shows us that we should not fear investing as we just do not know what is round the corner. What we need to make sure however, is that we put in place the correct investment strategy for your time horizon and personal liquidity. We must then work with you to control your natural temperament to ensure that, should we encounter a fall in markets, we can stick it out and reap the rewards over the long term

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[1] Exploring Risk and Return, Michael Fraser-Jones, 2017 https://woodfordfunds.com/words/blog/exploring-risk-return/?utm_source=blog-alert&utm_medium=email&utm_campaign=exploring-risk-return
[2] The imaginary story of Bob was originally highlighted in an article by financial writer Ben Carlson

General Disclosures: This article is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. The information, opinions, estimates and forecasts contained herein are as of the date hereof and are subject to change without prior notification. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. The price and value of investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.