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The Reality of Investment Risk

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June 28, 2016

The financial services industry is founded on catering for the risks of either dying too soon or living too long.The financial effects of dying too soon can be evaluated and the risk then covered through the use of life assurance.

The issues of living too long are more complex and the real risks are often overlooked by even the most sophisticated investors.

Investors generally have an intuitive grasp of what they perceive as investment risk but in many cases that perception is based simply on the fear of making a definable financial loss.

Rarely does the typical investor take into account the far more serious but much less obvious risks associated with their own life expectancy and the onerous erosive effect of inflation.

With improvements in medical science (particularly over the past twenty five years) a man who has attained the age of 60 nowadays has a life expectancy of 21 years. Contrast that to the situation 25 years ago when the life expectancy of a 60 year old was just 16 years. That is a substantial increase and brings with it a considerable increase in risk.

Developing that theme, a man of 65 now has a life expectancy of 17 years whereas in 1987 it was 13 years and a man of 70 has an expected 14 years ahead of him as opposed to the 10 years he could have expected to live for in 1987.

A similar situation pertains for female lives. A woman of 60 today has a life expectancy of 24 years (up from 20 in the late 1980’s), whilst a 65 year old female would now be expected to survive for another 20 years (up from 17) and a 70 year old has an expectation of 16 more years (increased from 13).

Continuing improvements in research and medical care will further extend the average life expectancy of those living in the developed world.

Quite simply we are living much longer and the finances we have built up will be required to see us through a longer period of time than we may have originally planned for.

Whilst this alone poses a real risk and a grave threat to our personal financial stability and security that risk is magnified much further when we take into account the effect of inflation.

Even a modest level of future inflation has a severely detrimental effect of the real value of our capital and income. We are told that inflation in the UK is currently running at just under 3% per annum.

If it continues at that level then over 5 years it would reduce the real value of our finances by 14%. Over 10 years the effect is more onerous and translates to a reduction in value of 26% and over 15 years the impact is an even more considerable fall of 37%.

Putting that into monetary terms, £100 at today’s values would effectively be worth £85 in 5 years time, £73 in 10 years and just £63 after 15 years of relatively low inflation. Of course, if the rate of inflation rises then these falls in purchasing power become even more significant.

The combined impact of increased life expectancy and future inflation pose a very substantial threat to one’s financial wellbeing and yet these significant risks are all too often overlooked when investment decisions are being made.

An investor opting to take what he believes to be a low risk investment (simply because he is fearful of making an investment loss) is actually leaving himself exposed to the much greater ‘hidden’ risks of extended life expectancy and inflation. As the figures above illustrate, the investor would be in grave danger of unwittingly making his financial position much worse. Sleepwalking towards financial disaster would not be too strong a description of this scenario.

Decision making in relation to investment

It has long been proven that investment in equities has been the most efficient way to maintain pace with inflation over a period of time. The importance of maintaining the integrity of your income and capital cannot be overstated, particularly in light of increased life expectancy and the effect of future inflation.

As has been demonstrated above, inflation erodes the nominal value of your capital and so it is essential to maintain the value of your wealth and the purchasing power that flows from it.

In order to do so it is necessary for your investment manager to try to preserve and grow the real value of your assets through a measured exposure to investment risk. The risks associated with stockmarket investment can be controlled through astute selection and consistent monitoring.

At Quotidian we only make investments where and when we feel that the potential for profit is compelling and we scrutinise our investment decisions on a daily basis.

We seek to invest in assets that have strong liquidity and are readily tradable. We apply a combination of technical analysis and fundamental analysis in arriving at our investment decisions. In so doing, we seek to maximise investment returns whilst controlling exposure to equity risk.

As part of our risk control process we are content to switch into money for extended periods if markets are relentlessly negative and less likely to produce a profit commensurate to risk.

We strongly recommend that investors combat the detrimental risks of longer life expectancy and inflation by including selective and controlled exposure to equities into a well planned investment portfolio.

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