Chapter 5: Why risk is important?
People have very different ideas about what constitutes risk, which can also change as their personal and external circumstances change.
While no person likes to lose money, some people have no tolerance for any loss at all, while others may be able to take a substantial loss before they get worried. This is often linked to the level of wealth the person has and the demands on the income.
A cautious investor prefers careful growth with a high amount of safety and the aggressive investor goes for maximum growth, even if it means taking big risks. In between the two extremes we have the balanced investor who prefers a calculated balance between growth and safety, with more emphasis on safety or the growth-minded investor who prefers a healthy strategy for growth, but with some security measures.
The different risks we will look at are those common to what an investor will face during retirement planning:
In retirement we have to add extra risk. These risks are health and the risk of living too long!
Let’s investigate these risks in our next few chapters.
A real danger is buying an asset when the price is high. When we purchase a property, we take out a loan unless we are really well off. If we want to sell the property we would like to get our money back and possibly a little more. If we buy when the price is high for the area and sell when the price is low, we will lose money.
This is called demand and supply and it forms the basics of economics. If I have an item you really want you will offer to buy it. If that item is really rare, you will have to pay my price, to buy it from me since I will not sell it cheaper and you want it.
If I need to sell an item that is available anywhere, you will be able to negotiate with me and if I really need to sell it, I may end up by selling it to you for a price which is close to what I paid for it. If I am desperate to sell it, the price may be even lower than the cost price.
Technology is a good example of this. Let me give you an example of buying high. My first calculator cost me a full one third of my salary as an apprentice for the Post Office in 1979. I spent the month begging people for food to eat. Today, that same calculator is less than a price of a bottle of milk. Why, because every mobile phone has a calculator like that, available with cameras and other items. Another example is how expensive a mobile phone was, when they first came out in 1973? No one could afford them but the extremely wealthy. My first mobile phone in the 90s, made a brick look light. No person today, would want an old Nokia, when they can have a new phone for the same price or less.
Companies will sell their stock at low prices when they see they may sit with unwanted items, this may be due to the item being dated such as my first calculator or because too many companies are making such items. They call these occasions- sales. If you sell the stock for a price lower than it cost to make the item then you have made a loss. We call this selling below cost. Selling below cost can cause a company to go out of business, since they cannot meet the expenses called overheads.
Volatility plays a role in price risk.
Volatility is where a price of an item goes up and down. It is affected by a variety of situations.
A stock’s price can be affected by factors inside the company, such as a faulty product, union actions or by events the company has no control over, such as political or market events. This volatility can cause a good equity stock to lose value just when you need the stock to be sold (timing risk) and will contribute to your capital amount risk.
The capital amount risk will depend on a variety of facts. One of these will be the timing of when we need that capital amount and the other is how much you are able to save, in order to meet the capital need when you need it. When I bought my asset, the calculator, then let’s suppose, I had decided I preferred eating to studying, I would have sold the calculator. If I could not have got the price I needed on selling the calculator that would be a capital amount loss, if I could sell the calculator for more that would be a capital gain, and I would be a richer person. Why? Because I would have bought another calculator and sold it for a profit again, and another and another, each time making a profit.
We each have a working life of around forty years, if we are employed. In these forty years we are expected to save sufficiently to support ourselves for another possible forty years in retirement.
Let’s start our exploration of the wealth creation journey, twenty years before retirement. This should be when you are at the high point of your career earning the maximum income for your labour. From the age of forty-five, income will start to fall on an average for this age group. The reason is quite simple. This age group has been increasing their earning capacity due to experience and natural demand. At forty-five you are normally earning more than an organisation will pay for a new recruit. What does this mean?
It is a sad fact that this means you will be the person companies will consider to retrench due to your high earnings and the fact you are considered an older worker. The way to prevent this is to continue letting the organisation sponsor you for learning new technologies or to ensure you have a long time with the company. Both time and cost factors that the employer puts into an employee reduces the chance of retrenchment. Unfortunately most people in this age group will fail to study due to the increased demands on their time and a slowing down of the energy that accompanies this stage. Very often they have changed jobs multiple times chasing earnings.
After 45 years of age, women will be going into menopause and men, andropause or male menopause. Both stages can result in a natural fatigue with a diminished sex drive, reduced muscle bulk and strength, night sweats, infertility, depression, loss of body hair, swollen breasts, palpitations, height loss, fatigue, irritability, reduced self-confidence, poor concentration, memory loss, sleep problems, increased body fat and anaemia. In other words, you may not be a delight at work!
At this point you are 240 pay checks away from the day you will draw your last payment from an income statement and start to live on your balance sheet. You need to be saving at least 15% of your income from age 20 if you are to be able to survive retirement.
Hopefully at this point saving 15% of your income has become a habit and you are not tempted to delve into the savings to support the children in a private school, or buy junior a house. It is also at this point the chance that you are in a relationship and costs are high for living.
Those savings are important. You can save your income in non-pension fund vehicles, but a pension fund is far more tax efficient. Not only does the government give you an allowance to deduct from your taxable income amount. (In South Africa the lesser of up to 27.5% up to the value of R 350 000 per annum), but also there is no capital gains tax or interest taxed in the fund. The fund is protected from any creditors and is protected by strict laws which will not allow government, or any other person to plunder it. The only product that matches it for the return is a tax free investment, however that is made from after tax money. If you have a chance of tax free investments in your country, then use them to ensure you have at least three months’ salary in them. This is your rainy day account.
10 years to retirement to go and hopefully you survived your forties and are into your fifties. At this point you are even more endangered, by the younger generation, in terms of job loss and the chances are it will take longer to get a new position, should this happen. 18 months is the average time to find a job after fifty, although this varies from country to country and is dependent on the skill sets of the person.
At this point retirement saving is so far away, that for most people, it still is not a reality. However we are fast reaching a situation where a retirement plan is becoming expensive and unaffordable for those who have not been saving for this event. This is a risk. Delaying saving has created the situation where to create a capital amount, to pay a passive income, will require a high percentage of the income. Often we find people have withdrawn savings, to meet the needs of a growing family, or parents in need. Should they not be disciplined the savings plan may never recover.