It’s a Sunday afternoon, you can see the sun is shining in Monaco, and you’ve sat down to watch Formula 1. Button and Hamilton are going head to head, as they race around the track, going faster and faster, closer and closer; you can barely watch because the risks they’re taking at 200mph are seemingly unfathomable. But Formula 1 is backed up by decades of data, years of training, and stress testing. Those drivers know exactly how hard they can push the car. This is just like investing.
In recent years investing has become much more like Formula 1 than you perhaps realise. As you hunt for higher returns (or try to beat the car in front), you push harder, taking on more risk. You do this within the limits of your investment framework (or car). Setting that framework is the first rule of investing. How far are you prepared to go?
Why the pressure on investment returns?
Over the last decade we’ve witnessed a fundamental change in the global economy. We had a huge financial crash, plummeting most of the developed world into recession. Central banks and governments around the world have worked hard to dig us out of a recession, and arguably they have been fairly successful at this. But the world they’ve left is very different to the one many investors are used to.
Interest rates are now so low that it is hard for a bank to make money, so they haven’t been lending at the rates we might expect them to. That makes it harder to get returns without taking on more risk. But investors attitudes haven’t necessarily changed, they aren’t prepared to take on more risk, but they want the same result. That means that fund providers have had huge cost pressured placed on them; an instrument that cost 0.7% seven years ago could now cost around 0.03%.
The lower the cost, the more of the returns you see.
How fast should you go?
We’re now in this world where investing is cheaper than it used to be and we’re keeping more of our returns. But interest rates are going even lower, and we’re still not seeing the returns we want to. Once you’ve controlled cost, you have two other levers to pull. The first is time, stay invested in the market for longer and trends suggest you’ll see growth over time. The second lever is much more complicated and that lever is risk.
How much risk are you prepared to take? And do your past actions match the answer you give to that question? Taking controlled risk is the key to smart investing. Everyone who signs up with Moneyfarm takes our survey, built using behavioural economics, to assign them to an investor profile. This profile takes into consideration your financial circumstances, your investment knowledge and your time horizon to give us a volatility level that suits your profile.
That means we’ll never take on more risk than the level that is right for you. Much like a Formula 1 team, we create a framework to get your money working as hard as possible. We won’t go outside of that framework and we’ll only invest using cost-efficient instruments such as exchange-traded funds. That leaves you with the third lever… time.
