Volatility Isn't the Same as Risk

Imagine two investors who each have $1 million invested in exactly the same portfolio.

Both experience a market downturn that temporarily reduces the value of their investments by 20%. On paper, each has lost $200,000.

One investor has sufficient cash and other readily available funds to cover their foreseeable living expenses. They can afford to leave their investments alone and allow time for markets to recover.

The other investor needs to withdraw $100,000 over the coming year to fund their living expenses. They have very little money set aside outside their investment portfolio.

Both investors have experienced exactly the same market volatility, but have they experienced the same risk?

I would argue they haven't. And understanding why gets to the heart of what I believe good investment management is really about.

We've confused volatility with risk

Much of the investment industry treats volatility, the extent to which investment values fluctuate, as a measure of risk.

The greater the fluctuations, the greater the assumed risk. This thinking underpins much of the traditional approach to constructing investment portfolios and assessing an investor's tolerance for risk.

But there is a fundamental problem with this approach. A temporary fall in the value of an investment is not necessarily the same as a permanent loss of money.

The distinction matters enormously.

An investor who can leave a well-diversified portfolio untouched during difficult market conditions has choices that someone who must sell assets to meet living expenses does not.

Of course, markets aren't guaranteed to recover within any particular period, and some investments suffer permanent losses regardless of how long they are held.

Nevertheless, the ability to decide when to sell rather than being forced to sell can make an enormous difference to an investor's long-term financial outcomes.

The danger isn't always the market. Sometimes it's your circumstances.

Consider someone approaching retirement with $2 million in investments and annual living expenses of $100,000.

Their annual spending represents just 5% of their investment portfolio.

Now suppose that person has enough readily accessible money set aside to cover two years of anticipated spending. A significant market downturn might be uncomfortable, but it needn't immediately disrupt their lifestyle or force them to sell growth investments at depressed prices.

Contrast this with someone who has the same $2 million invested but no accessible reserves and substantial expenditure commitments falling due.

The investment portfolio might be identical, but the second investor is much more exposed to the consequences of a market downturn.

This is why I believe investment risk needs to be considered in the context of the investor's entire financial circumstances rather than simply the characteristics of their investments.

Why I start with cashflow, not a risk questionnaire

When we begin working with a client at The Updated Investor, one of the first things I want to understand is what their money actually needs to achieve.

How much does it cost to maintain their lifestyle? What major expenses are on the horizon? How much income can they rely upon? What financial commitments must be met regardless of what investment markets might be doing?

These questions help us establish how much money needs to be readily available and how much can genuinely be invested for the longer term.

Only then does it make sense to consider how that money should be invested.

Traditional risk questionnaires can have a place in understanding an investor's attitudes and reactions to uncertainty. However, I don't believe a questionnaire score should dictate an investment portfolio without first considering the investor's financial capacity to absorb losses.

Someone might be perfectly comfortable watching markets fluctuate but unable to afford the financial consequences of a significant downturn. Equally, someone might be uncomfortable with volatility but have sufficient resources to avoid making investment decisions under pressure.

These are two very different situations, and they deserve different conversations.

Liquidity creates choices

One of the principles underpinning our investment philosophy is liquidity.

Quite simply, we want to know that clients can access their money when they need it, without being unnecessarily exposed to the risk of being locked into an investment or forced to accept an unfavourable price.

That doesn't mean all investments should be held in cash. Far from it. Holding too much cash over an extended period introduces another risk: inflation can steadily erode its purchasing power.

Nor does it mean every investment should be capable of being sold immediately. What matters is matching the availability of money to the purpose for which it is held.

We also remain cautious about investments that appear relatively stable simply because their underlying assets aren't valued or traded frequently.

An investment in an unlisted property or mortgage fund, for example, may display very little day-to-day price movement. But that doesn't necessarily make it safer than a diversified portfolio of listed investments whose values change every trading day.

Indeed, an investment that appears stable but cannot be sold when the investor needs their money may introduce precisely the kind of risk we want to avoid.

An investment's price moving every day doesn't necessarily make it dangerous. And a price that rarely moves doesn't necessarily make an investment safe.

The real objective is Financial Certainty

This brings us back to the central theme of this investment series.

Investing isn't an end in itself. It is a means of achieving something more important.

For most people, that means being able to meet their financial commitments, enjoy their lives and feel confident about the future.

That's what we mean by Financial Certainty.

It doesn't mean eliminating uncertainty, because that simply isn't possible. Nor does it mean avoiding all investment risk, because doing so may make it harder to achieve long-term goals.

Instead, it means understanding the risks that actually matter and managing them in a way that supports the life you want to live.

A well-constructed investment portfolio should do more than pursue returns. It should be part of a broader financial plan that recognises your cashflow requirements, anticipated expenditure, capacity for loss and the importance of having choices when circumstances change.

Markets will fluctuate. Economic conditions will change. Unexpected events will occur.

The question is whether your financial arrangements are sufficiently robust to deal with those events without unnecessarily compromising your lifestyle or long-term objectives.

That's the kind of risk management I believe matters most.

And it's another reason why good financial planning should come before investment selection.