Blogs | April 10, 2019

Taking chances can be lucrative, but how risky are we really?

People face risks when they’re deciding how to manage their money. Most want to make sure their money grows but they are nervous about suffering losses. That’s because the outcome of their decision is usually uncertain.


When it comes to investing, every decision carries some degree of risk. Investments in shares, bonds, and investment funds can lose value – even all their value – if market conditions worsen.

Even conservative investments such as bank accounts can lead to losses if high inflation outstrips the rate of interest. This means that while they will earn interest on their savings, this will not keep pace with the rising costs of goods and services. This is known as a real terms loss.

Richard Nixon, whose risky behaviour cost him the US presidency, was one of many who summed up that dual aspect of risk when he said: “If you take no risks, you will suffer no defeats. But if you take no risks, you win no victories.”

Gain or loss?
But how risky are we, really? To answer that, we have to look at how people decide between alternatives with uncertain outcomes.

People make decisions based on their expectations of making a loss or gain compared with how much money they have now. An important element is the idea of loss aversion, meaning that individuals are more concerned about losing what they already have than what they might be able to gain. This has an impact on people’s personal financial decisions. Given a choice of equal probability, individuals will choose to preserve their existing wealth, rather than take a risk that might lead to more wealth.

Another strategy people take to manage risk is to seek safety in numbers. Just as an antelope stays with its herd to minimise risk from a predator, investors tend to buy into a rising market, whether shares or property, and rush to sell when others do. The danger is that although people think they are minimising risk by following other investors, that stampede can drive up the price of an asset to an unsustainable level, at which point the bubble will burst leading to a fall in prices that will leave people nursing heavy losses.

Share picking
Whether or not we acknowledge it consciously, we take risks with our money every year. In the year to April 2018 some 2.8 million Britons invested £28.7 billion in Independent Savings Accounts (ISAs) based on stocks and shares. While gains on ISAs come tax-free, investors can still suffer losses if shares held in the ISA fall.

Many workers pay into pension schemes, most of which are based on investments in shares and bonds that may rise or fall in value by the time the investor retires. This is called defined contribution (DC) and means the employee must bear the risk of the values falling. The alternative is a defined benefit (DB) scheme where employers take more risk by committing to paying a specific annual pension depending on the number of years worked.

As of 2016, only 1.3 million people were actively contributing to a private sector DB scheme, down from 3.7 million in 2005 compared with 12.6 million people in DC schemes, up more than 400% since 2010. This means risk has transferred from employers to employees.

Stocks and shares
Some investors take on more risk by buying specific shares they believe will rise in value or deliver a healthy income in the form of dividends (a payment to shareholders twice a year depending on the company’s performance). According to modern portfolio theory, fully rational risk-averse investors hold well-diversified portfolios of shares.

However, scientists now believe investors are subject to unconscious biases that lead them to take unwise decisions. The main danger revolves around the human instinct to trust in our abilities and judgement. We can fall victim to over-confidence in our abilities and also assume decisions that turned out well were due to our own abilities rather than luck or other factors.

One emerging alternative is robo-investing. Using machines to give financial advice could remove human bias and make financial decisions cheaper. However this raises concerns investors could suffer in the case of technological glitches or if the AI fails to interpret their needs correctly.

Mitigating risk
Even if we do not make risky decisions with our money, we have to deal with the risk something bad and potentially financially ruinous could happen, such as being involved in a traffic accident, or our house burning down. Few want to assume those risks as that would mean paying the costs out of their own assets. Most people would rather minimise the impact of that risk by taking out an insurance policy.

People can also mitigate the risk to their family’s finances from death or an injury that keeps them out of work by buying life insurance. In all these cases people choose to pay a relatively small sum rather than risk suffering a much larger financial loss in the future.

Investors need to realise they cannot eliminate risk but can take steps to minimise their exposure to it.

InvestingRisk

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics