A few weeks back, we tried to answer the questions: How Much should I save? We talked about the following 4 points:
1) What are you saving for?
2) Defining your time horizon
3) Defining your savings ability
4) Implementing and monitoring your plan
It holds true in financial markets that the longer your time horizon to invest, the higher your ability to stomach risk. You hear about this “risk” thing quite a lot, but what do we mean when we refer to risk?
At Ternary, risk is defined as the probability of achieving an undesirable outcome.
Example: You are 33 years old. You would like to save for a house deposit to be paid in two years’ time. An undesirable outcome in this example would be investing for 2 years with your hard earned cash, and walking away with less than you invested.
So, your adviser recommends a much lower risk portfolio than what your long term savings portfolio looks like. Why is that?
To answer that, we use past data and look at what would’ve happened at various points in history had you invested into three different portfolios with only a 2 year time horizon. We are using data from 1 Jan 2002 to 26 Mar 2015. The three investment options are represented by the category averages for:
1) Equity – General Unit Trusts (High Risk)
2) Multi-Asset High Equity Unit Trusts (Medium Risk)
3) Multi-Asset Low Equity Unit Trusts (Low Risk)
(THIS ANALYSIS IS FOR ILLUSTRATION PURPOSES ONLY, AS PAST PERFORMANCE DOES NOT GRANT ONE ACCESS TO THE CRYSTAL BALL OF INVESTMENTS)
Putting the above graph into context, we see that when investing into a Low Risk portfolio the probability of negative returns over a two year period will be 0%. This would be a great way to stack up the odds in your favor, and to avoid reaching an undesirable outcome.
Conversely, when investing into the Medium Risk portfolio you would have a 7% chance of losing 3% of your money after two years. Not ideal!
At the extreme, when investing in the High Risk portfolio you stand a 12% chance of losing 7% of your capital after two years. At this rate of inadequate decision making, you will have to save for a few more years before being able to afford that house deposit.
To see how we can help you reduce your probability of undesirable outcomes in your investments, and avoid inadequate decisions, get in touch!
