How should I consider risk?
Doug Webber Associate Director and National Practice Manager of Lachlan Wealth Management gives a detailed answer to one of our clients’ key lifestyle and financial questions. Email your questions to Lachlan Wealth Management.
As a financial planner, one of the most fascinating conversations I have with clients is around the issue of risk. Why is this so fascinating?
Well for one thing, most people don’t really have a clear understanding of what risk actually is. And second, they have no concept of how much of this unknown ‘thing’ they can, or should, tolerate over time.
So today, I’d like to share my views on risk in the context of a long term financial strategy.
Let’s start by attempting a definition. The Cambridge Dictionary defines risk as “the chance that something bad will happen”. Now this may at first sound like a totally useless definition. But if you think about it, it captures the very essence of risk in a financial planning sense. The only thing you have to do is decide what constitutes something bad.
As you watch this, I want you to keep an analogy in mind…the risk that you might get stung by a bee, and suffer some short term discomfort, doesn’t stop you from planting a garden that will flower for your enjoyment for years.
Possibly right now you’re thinking I’m the last person you’d ask for financial advice. But I really do want you to hang in there.
One of the first things I do with new clients is to help them establish a set of lifestyle and financial objectives. Then, we work out exactly how they currently look financially. Usually, there’s a gap between today’s reality and tomorrow’s hopes and dreams.
Here’s an example, focusing on a long term objective, to get you thinking.
My new clients, a husband and wife, begin our discussions by telling me they’re very conservative by nature. I believe them. They also tell me they want to retire in 10 years time and we discuss their income requirements at that time. We discover they need to grow their investment portfolio by around 4% a year after inflation to achieve their retirement when they want it.
I tell my conservative clients this:
- To achieve an average rate of return of 4% after inflation over 10 years, they’ll need to invest around 60% to 70% of their portfolio in assets with potential for capital growth – predominantly shares
- And over that 10 years, they can expect maybe 2 years when their portfolio will decline in value. And no, I can’t tell them by how much.
They’re concerned, naturally, since they’re conservative by nature. I know this because they told me so.
So we talk some more. I tell them we could invest instead in term deposits and the like. No chance of negative returns there. We should be able to get maybe 2% above inflation. They seem ok with this, until they understand:
- They’ll probably need to work for maybe 15 more years rather than 10, or
- If they do retire in 10 years, one or both of them will need part-time jobs for a long time after that; or
- They could still retire in 10 years, but with an income considerably lower than they want.
You know what they said to me? Oh, we don’t want to run the risk of having that happen….
The moral of the story? Simple.
My clients were initially thinking in a very traditional way about risk – they were worried about the prospect of losing money. In the end, they could see that there are factors that from time to time lead to short term ups and downs in some investment markets (particularly in the share market).
But they also had their eye firmly fixed on the long term objective they’d set for themselves.
With that knowledge, they decided to try to avoid the chance of something bad happening to them. They decided to plant the garden to enjoy in the long term, notwithstanding the short term discomfort that might come with a bee sting from time to time.
So which is it for you? The occasional bee sting? Or would you prefer to live in a desert?
Disclaimer: This general advice does not take into account your objectives, financial situation or needs and before acting on this advice you should consider whether it is appropriate to your situation.
