Any decent financial adviser will assess your capacity for loss when giving you investment advice. In fact, they are require to so it shouldn’t cost any extra. But what is it?
I think it’s easier to think about initially it in terms of your financial resilience. When you set off on any journey, the vehicle you travel in should suit both the distance required and the conditions you’ll experience along the way. You don’t want to hit bad weather in a tiny boat.
When investing, it’s important to remember that financial cycles inevitably bring financial shocks and turbulence with them. Your financial resilience is a measurement of your ability to weather these storms. It’s vital to understand how resilient you are as you don’t want to invest in something which may ruin you financially because you couldn’t accept the level of risk or volatility it brings with it.
Whilst you can use some simple questions to get started with this assessment, it’s important to bear in mind that an accurate result is entirely specific to your own circumstances. That means that the most comprehensive way of testing your resilience is to create a lifetime cashflow model which takes into consideration your income, expenditure, assets and liabilities over the duration of your life, factoring in some assumptions about taxation, inflation, investment returns etc. This will allow you to compare how much income you need versus how much you are likely to receive (as a very rough guide).
A few questions you can ask yourself to get started are:
- What would happen if I lost my job, do I have other insurances such as Income Protection to rely on?
- Do I have some cash savings I can easily access to cover short term emergency requirements, rather than rely on more expensive debt such as credit cards or loans?
- When do I need to access my investments as capital or for income? Market downturns, for example, only really impact on your quality of living when you need to access the invested money in some way.
- What would I be comfortable cutting from my expenditure for a period, and what is the minimum amount of income I am prepared to live on?
- How does all this make me feel? Do I worry about fluctuations in my investments even when it doesn’t make a material difference to my life?
Your age will probably make a difference
If you’re young, and putting money into a pension you can’t access for 25 years, that money can’t be accessed until your retirement age anyway. That means that the ups and downs of volatile investment markets won’t have a material impact on your quality of life as you can’t spend that money now anyway. This doesn’t mean you should take as much risk as possible, your own attitude towards risk is also important, but you aren’t reliant on that money for income right now, and you’ve got longer for a market crash to recover again. Other risks such as losing your job, and struggling to make mortgage payments, are more likely to be significant at this stage, as is building up some emergency cash to use as a buffer when needed. You need to know you can afford to make the investment in the first place.
When you’re in retirement and reliant on your pension or savings for the income you need to live off, your capacity to withstand the impact of a financial loss without curtailing your expenditure is far more important. You don’t necessarily to need to worry about losing your job (although many will work part or full time beyond 65 nowadays) but your pensions and savings money is what you’ll live off, along with what state benefits are still available. Whether you take your money as capital (encash some of your savings every now and then) or income (your investments generate dividends which are paid to you) a financial loss due to investment market conditions at this stage of your life is more likely to have an impact. Given average life expectancies are constantly on the rise there’s a very good chance that any monies invested will go through at least one big downturn during retirement, so it’s important to plan for the worst even if you hope for the best.
Any market downturn is amplified if you need to take income from your investments during a market downturn. This means its far better to draw money from a cash account during a market dip whilst your investments recover. Building up a significant reserve for this is important if you decide to stay invested in retirement rather than purchase a guaranteed income product such as an annuity.
Testing the impact
Different advisers will have different ways of testing the impact of a financial loss and assessing your financial capacity to sustain it. Remember, they are required to do this so feel free to ask about it.
Every adviser, when recommending an investment portfolio or fund, will be able to show you how that portfolio or fund has performed under the worst financial conditions, such as the 2008 market crash. This gives you an idea about what has happened before and you can compare this to less or more volatile investments to get a feel for the differences. What it doesn’t do is relate this to your own personal circumstances – how would this loss have an impact on your lifestyle, the holidays you take, the amount you have to spend each month? Nor is it an indication of what the future holds – we know what happened in the past but have no idea where the next crash will come from and how it will compare to the last.
The best way to assess your financial reliance given is not just to test against what has happened in the past, but to understand what your minimum income requirement is and work out how big the drop in investment markets would need to be to breach this. If you know it would take a known percentage drop in your investment portfolio to have an impact, you can look back through history and establish how often this has happened and the probability (it’s still only a guess based on the past) of that happening again.
The upshot might be that you decide to take a little less risk with your investment portfolio on the basis that it improves the probability of you never needing to cut back on your expenditure, and that’s more important than generating extra returns – especially if you don’t need them.
That’s why assessing your capacity for loss is always personal to you. It involves assessing a number of objective criteria based on your income and expenditure, and how much you can afford to lose. It also involves a decision which only you can make around whether you want to trade off additional security in return for additional gains. If you’ve paid for advice, make sure you ask about it. If you invest yourself, make sure you’ve thought about it.
Some rules of thumb
- Keep back at least 3 months expenditure as emergency cash. More if you’re in retirement and reliant on investment income from equity markets.
- Don’t invest in equity markets unless you intend to be invested for at least 5 years.
- If you have debt consider paying that off first.
- Check your employment contract for rules on sick pay. How long would you need to be off sick before this had an impact?
- Consider an income protection insurance especially if you’re self-employed. If you have one, do you have enough emergency cash to cover the deferred period?
- If you’re reliant on your investments for income, set aside a significant amount of capital to ride out a market downturn without having to draw down on your investments. Could you survive for a year or more by taking your income requirements from cash instead, whilst the market recovers?
- Be honest when working out how much you spend. Take your last 12 months bank statements, add up the outgoings and divide by 12. Does that equate to what you think you spend each month?
Remember rules of thumb are there start you thinking, they aren’t specific to you and the answer might be completely different dependent on your circumstances.