Bill Jamieson: Finding a level of risk we are happy with is hard

BRILLIANT! Having spent Christmas and New Year in a blue funk getting our tax affairs sorted in order to avoid fines and penalties if we miss the 31 January deadline, we now learn the staff at HMRC are planning a strike on that date.

Maddening, or what?

For many this period of tax reckoning is not just the darkest part of the year but also one in which major investment decisions are made – liquidation mainly, breaking a cardinal rule that investment decisions should never be dictated by tax consideration. Ideally of course, freelance workers and the self-employed should set aside a percentage of their gross earnings into a “tax pending” savings account as they go along. But how often does this happen in reality? Very rarely, I suspect.

The other day, a valued contact of mine let fall that he was having to sell investments to meet the tax deadline and was bemoaning the poor performance of his portfolio of shares. He now had to sell some investments at a loss. This was not at all what he expected. He thought his stockbroker had invested too heavily in “risk” stocks. Should he change his stockbroker? What would I advise?

My immediate recommendation was that he should first deal with the tax liability: explore a last-minute contribution to his pension plan to help reduce the bill, sell or transfer what is necessary and get shot of this worry as a priority. After that is when the hard thinking starts about saving and investing for the future.

This might seem to be a relatively simple issue of planning for future tax liabilities so that the problem of “forced disinvestment” does not again arise. But before we get to this point, a more profound issue has to be addressed. How much risk are we prepared to take on? The first question any stockbroker or investment adviser will ask of any potential client is their tolerance to risk.

This is the most searching question in finance today and it is not at all surprising that in the investment landscape we are now in, most people give the wrong answer. Presented with charts showing how impressive total returns can be achieved by investing in a set of risky assets, many will rate themselves as having an “average” tolerance to risk, or even a tolerance of “medium to high” risk.

The problem is that these categories are so vague as to be, at best, of little practical value and at worst positively dangerous. This is especially the case in the volatile conditions that have prevailed in equity markets for more than a decade: three major falls in the space of 12 years. Were investors presented with a chart showing the peaks and troughs of the FTSE 100 since 1997, our attitude to risk would be altogether different to the stock answer of “average”.

Self-assessment of risk tolerance is arguably more searching and vexatious than a self-assessment tax return. Investors who in everyday life have a low risk tolerance and are risk minimisers somehow consider that in stepping on to the Big Dipper of stock market investment, this volatility will not apply to them or that their investment decisions will be of a superior quality. When reality is encountered and their investments perform little better than the market (or worse) it is of course the stockbroker or adviser to blame.

This problem of risk assessment is further sharpened by the deep uncertainties now prevailing in financial markets: “low visibility” in the jargon. If investors truly believe they can successfully read through the eurozone sovereign debt crisis, how Western economies are to get shot of their debt problems and what lies ahead for China’s economy, then millions would now be stretched out on Seven Mile Beach Grand Cayman watching our yachts gently bobbing in the azure waters.

Successful investment is about much more than stock or fund selection. It is about coming to terms with that profound question in life: know thyself. And even when this question is addressed, we need to consider also the ever-changing nature of the investment universe.

Asset classes that in one era are considered low risk or “safe” bets have a disconcerting habit of morphing into highly volatile and vulnerable areas for investment. Government stocks and corporate bonds have been considered “low risk” investments. But the apprehension in markets today is of a bursting of the “bond bubble”. Meanwhile, those opting for a defensive, “low risk” strategy of hugging income orientated shares and funds find this investment universe to be small: a very limited group of shares held by a large number of income trusts; and even those shares that have come to be regarded as “low risk” (such as Tesco) can spring nasty surprises.

The solution for the low risk investor is asset and geographic diversification; a significant holding in fixed interest bonds or index-linked government stock; equity investment confined to large-cap companies offering some reliability of income and above all a cash pool for emergencies and those pesky tax demands.

Switching stockbrokers is no substitute for some honest soul-searching about our real tolerance of risk in a highly uncertain and low-growth world.