My financial life in 3 Pots…#061
Managing investment risk for humans
I wrote last week about my market jitters; my walk in my client’s shoes.
Coincidentally, a friend who is five years give or take off retirement, asked me to take a look at her investment strategy.
Her pile of cash and portfolio choice caused me to think about risk. A subject that is ill explained or understood by most.
Risk
Risk surrounds us. We take risks every day – crossing the road, driving a car, riding a bicycle, the time we leave to reach our destination or eating food past its sell by date. We barely even think of these activities as risks, so familiar are they to us. Our highly evolved brains consciously or subconsciously weighs up the risk and off we go. The impact of getting these everyday decisions wrong is wide, ranging from a mere scare to fatal.
But the impact of not taking a risk is equally consequential. If we didn’t we’d barely leave the house or empty the fridge.
And so it is with investments.
Take too little risk and you may not accumulate enough wealth to live on in retirement.
Take too much risk and you may also not accumulate enough wealth to live on in retirement.
Misunderstanding this investment risk paradox means many miss out on growth opportunities. I see this particularly in women, as for my friend.
Shares and risk
Investing in shares is buying a slice of the great companies of the world. The best way to do this is through a widely diversified, global, low cost, tracker fund. This type of fund smooths out the impact of individual companies going bust or specific countries being out of favour.
The reason to buy shares via a fund (‘Your Portfolio’) is to achieve a return on your investments over inflation to protect the real value of your money. To maintain ‘purchasing power’.
Uncertainty
The ups and downs – known as volatility - of the share market (and your portfolio) are to be expected. The downs can be uncomfortable. The key thing is not to be panicked and sell. Temporary falls in the value of our investments are to be expected.
Uncertainty about how far the market will fall and how long it will stay down is normal. However history shows that the longer we hold our investment, through the rises and the falls, the greater our chance of a strong return.
Dealing with uncertainty
Uncertainty is a tricky beast. None of us like it. But in investment, it’s the price of admission if you want to stand a chance of an above inflation return over time.
My three tips to manage uncertainty are:
Manage your emotions – stay calm. Tune out the 24/7 media circus and stay focussed on your long term plan.
Stay invested - don’t try and time the market by thinking you can sell at a high and buy back ‘at the bottom’. This is a fools error.
Remember - the ups and downs are to be expected.
Easy for me to say I know, harder to do in real life. But mastering this is an important part of managing your long term investment success
But what happens in real life when investment markets - and your portfolio - fall and you still have a life to live and pay for?
Hello 3 Pots
I picture my financial life in 3 Pots – Short, Medium and Long term. I used to draw the sketch above for my clients too.
The size of your pots will vary depending on your life stage. The aim at or around retirement, or when moving into a lower income period, is to have the right balance between ‘Your Portfolio’ (that is, your shares and bonds1) and cash in the three pots.
The correct balance will depend on your personal circumstances and comfort with risk:
If you have a secure income – whether work, company pension, annuity or rent – you may need a lower level of cash in your Short Term pot.
If your income is reliant on your investments – which could be in any of the following ‘wrappers’ - pensions, ISAs, General Investment Accounts or On/Offshore Bond – it will be subject to market movements. Ideally we don’t want to sell investments when the market falls. The antidote is to hold sufficient cash to live off, potentially for a sustained period, until your portfolio recovers. This means holding 3-5 years of your expenditure, if not more, in cash, fixed term accounts and low risk bonds in your Short and Medium Term pots.
The right amount of cash for you is the amount which balances growth or wealth preservation V sleeping easy at night.
No one can predict the future
No one can predict the future. Risk is all around us. A woman stepping away from work at age 60 has a life expectancy of 87. Nearly 30 years!
My 3 Pots strategy helps balance the need to achieve long term returns over inflation with cash to protect your short and medium term.
And of course, this is where a great financial planner2 who can educate, guide and empathise with you is worth their weight in gold.
You
As ever, I’m interested in you. How do you think about investment risk? – does it worry you? And how do you manage it? How do you see the 3 Pots working for you? What have I missed?
Brew yourself a cuppa, grab a biccie, and drop me a line, I’d love to hear from you.
Until next week my friends
Ruth x
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Bonds are debt to governments or companies which some use to balance the risk of shares.
If you need a financial planner recommendation, ask me.