I see risks

Risk is a word bandied about a lot and, much like it’s cousin, investing, is one which is often used misleadingly or incorrectly. Risk has many different forms – market risk, inflation risk, liquidity risk etc etc, but actually these are more volatility risks, if you excuse the mixing of terms. When it comes to personal measure of risk I think that one of the better ways of thinking about it is the following:

Risk is a two stage affair – initially, the chance of the event happening, then secondly, the impact that event has, and it’s a consideration of those two which helps properly guide you in making decisions.

So, take two games. First one involves throwing a dice, you call a number and throw the dice. The terms are; you win £1,000 for choosing a number which doesn’t land face up; so you call 3, roll the dice and if it comes up 1, you get a grand, but if you say 3 and roll a 3, you lose £1,000. Now whilst research tells us we feel losses twice as hard as we feel gains, the odds are surely worth having a go, if not several turns at it.

Change the game and make it Russian Roulette - make a successful call a win of £250k, a life-changing amount of money, but calling the number that comes up results in a fundamentally prejudicial life altering outcome. I can’t imagine many people, beyond Derren Brown, would play that game, the chance is the same as the first game, but the potential negative outcome holds a much worse outcome.

So to risk in investing. Equity exposure “normally” give the greatest returns, but carries proportionately greater risks. Spending 100% of your salary means any drop in income will lead you into (probably further into) debt and therefore losing your job has a dramatic and material impact – it’s not life threatening, but as one homelessness charity found in a study; most people are only three missed paychecks away from living on the streets. To offset this, we should seek multiple income streams which is diverse enough to see us through a dip or eradication of one and is a well-trodden path to FI.

I have one job (no side work) and various investments building up in various ways underpinned by a solid emergency fund. The fact that I have a good emergency fund allows me to put more money into my ISA and pension. The fact that I seek to limit my expenditure means I have money left over to buy more shares directly and if I were to be put on notice of redundancy I could save a few more thousand pretty quickly.

Taken as a whole, therefore, my equity allocation is probably at a level which would describe me as financially aggressive… but that doesn’t really reflect my, albeit self, perception. Zoom out and consider everything together and the picture changes. Going back to the two stage risk analysis the negative monetary events which could occur are matched or off-set:

Source of Risk	Negative event	Risk of event happening	Impact on me
High equity exposure	Market downturn / crash	Medium to high. Drawdowns happen, we’ve had a few since last summer already and are a fact of life with the markets being driven by emotional humans.	Low as I’m buying for the long term and am in no way reliant on that capital value or income day to day and £ cost averaging helps me in this accumulation phase
Employment risk	Redundancy	Low. Company and economy linked. I think the company risk of bankruptcy is low. On the macro scale, the company could be laid low by larger market forces tied to a recession, but it did okay in the last one, so considered low. My personal chance of being redundant is relatively low, but shouldn’t take that for granted!	Low in the short term, higher out to 12months. But generally I would hope I am employable within that time frame, so considered a low risk. Further mitigated by increasing ISA balance from regular investment which could be tapped for income if required.
Higher cash balance	Inflation	Low in the short term: I’m getting close to 0% interest, though inflation is close to zero too. But inflation is tricky and my personal rate may be higher than official stats, and surely in the long term the risk is medium to high.	Low because I have a higher equity exposure which should provide returns in excess of inflation and because I have other income sources which can top up these levels if needed.

Pensions is a funny one as a good chunk of my regular monthly saving total goes into it, but I wouldn’t be able to access it if I needed to in the short term and the above is about covering unexpected events impacting income suddenly. Whilst pensions don’t really fit in the sudden category, however, the tax benefits and company match make it a no brainer not to take full advantage.

If you combine two risks together – market crash and redundancy, then that obviously makes for a more difficult outcome, but hey, that’s why we’re in this FI game in the first place!

If I can add more lines in the future then that’s all good, a buy to let would be great (assuming Osborne doesn’t just outright ban them). Assuming you have enough equity it should be its own, self-financing, little business; income covers outgoings and retained cash to cover larger expenses. If there is a recession you should be insulated when letting it (potentially lower income in the short term, but higher demand as people can’t afford to buy their own places), and if you lose your job then it shouldn’t matter hugely in the short term, ie until you seek to refinance it.

When I’ve done those ‘attitude to risk’ surveys I come out pretty middle of the road, not terribly adventurous, but because I have a reasonable hold over my emotions when investing, and have the above safety nets built in, for me personally (standard caveat about how I am not a financial advisor and you should seek your own advice / make your own mistakes) I am happy with a higher, more “aggressive”, equity exposure level for my particular set of circumstances.