10 Feb When being cautious can lead to more risk
Financial planning, as the name rather implies, is mostly about the future. Yes, sometimes it can help to identify things which we should do now to make a positive change in our financial circumstances immediately but mostly it is about doing things, whether now or in the future, to help create a better future for ourselves. In order to work out what these should be and when we should do them, we generally need to project forwards from our current circumstances. This will provide some insights into how feasible our goals are and also highlight where potential roadblocks might occur.
For example, it is all well and good to see that our resources are projected to be sufficient to meet all our objectives over the next 40 years but if we are likely to run out of liquid assets in the next five years then we might need to change something to avoid that happening.
There are essentially two elements to such a projection – the knowledge of our existing assets, liabilities, income and expenditure and the extent to which these are expected to change over our desired time horizon; in most cases this will be our lifetime.
For those of us not fortunate enough to be able to see the future with perfect clarity, the latter element will require some degree of assumption about how things are likely to develop over time. How to derive these assumptions and what they should be are issues which absorb the attention of professionals involved in the field because, particularly over long periods, they can have a huge impact on the projected outcome even where the rates are apparently small. For example, projecting an expenditure of £10,000 at an annual rate of 4.5% rather than 5% results in a difference of more than £12,000 a year after 40 years.
In reality, we have no idea how accurate our assumptions will be as the future is, as ever, unknowable. How many forecasters predicted the timing or impact of either a global pandemic in 2020 or a war in Ukraine in 2022?
Given the impact of getting such assumptions wrong, of which the worst could be running out of resources unexpectedly, it is not hard to see the temptation to adjust our assumptions with a view to being ‘cautious’. This might entail increasing incrementally the assumed rate at which expenditure increases and/or reducing the assumed return earned on invested assets. However, while such changes may appear at first sight to be increasing the robustness of the analysis by anticipating worse outcomes (higher expenses and lower resources in the future), the result can be the opposite.
Another variable, albeit one which is sometimes overlooked, is that of life expectancy. In financial planning this is of vital importance because it determines how long the available resources need to last. We can look at published data from the Office for National Statistics but that only provides averages, so by definition some people will live for a shorter and others for a longer period than the average. In most instances, the variability in life expectancy is at the upper end of the scale, in the period when we are not earning and instead are dependent on our accumulated financial resources to meet our lifestyle costs.
This means that the extent to which those resources are forecast to suffice can be highly dependent on how long they are assumed to be required to last. It is one thing to require a given value of assets to sustain expenditure for someone who lives until they are 80 but quite another to expect the same assets to last until they are 110.
The problem is that there are only so many levers that we can pull to influence our future circumstances. Even so, those affect our expectations of the future, not the actual situation today – the current position is fixed. If we assume that our expenditure will increase more quickly, then our resources will be consumed at a faster rate – since we cannot increase their value today, we must find a way to do so in the future. This may be by working for longer, achieving a higher net return on capital or some other route. The same is true if we assume lower investment returns – while reducing costs and improving tax-efficiency will have some impact, this may not suffice, particularly if those options have already been addressed.
This leaves us with the standard way of achieving higher returns which can be found in most investment textbooks – take more risk. The amount of risk we take is simple to control. We just allocate more of our money to those assets which have a higher risk where that risk is compensated for by a higher expected return. Not all risky assets have higher expected returns (ask anyone who has been speculating on cryptocurrency recently) but a diversified exposure to global equities is likely, over a multi-year time horizon, to deliver a higher return than a similarly diversified exposure to government or corporate bonds. Equities are riskier than bonds so investors demand a higher return in exchange for accepting that risk.
But hang on – wasn’t the purpose of assuming these higher rates of expenditure escalation, longer life expectancy and lower rates of investment return to be more cautious? Therein lies the contradiction – in trying to be more cautious, we can actually end up feeling obliged to take more risk and so be less cautious. The danger then is that we end up with a portfolio whose risk characteristics fall outside the range with which we are comfortable and the likely outcome when the market delivers a shock is that we realise that we can’t stand the stress of watching its value fall so much so we bale out and sell everything at depressed prices. That’s probably not going to get us where we want to be, particularly as nobody rings a bell to tell us when we should invest again.
Reliably predicting anything about the future is difficult but sometimes it is an exercise which we need to undertake because it provides a framework within which to make decisions. While most or all the assumptions that we make are likely to be wrong in practice, regular review of them to permit periodic course corrections is likely to provide a more robust approach than trying to adjust them artificially and ending up with the opposite outcome to the cautious one that we are trying to achieve.