risk and volatility
Specialist Pension Transfer Advice
Beginners guide to Pension investment risk and volatility
If you are thinking about transferring your old Defined Benefit (DB) pension scheme, there are many factors that you need to consider, not least of which is how your pension fund is invested.
Transferring from a DB scheme into a Defined Contribution (DC) pension scheme, such as a personal pension, means you will be moving into an arrangement where future benefits are reliant upon investments and how much is in the “pot” rather than a guarantee based on what you were earning when you left your old DB scheme.
In other words, you are coming out of an arrangement that has guarantees and where none of the investment risk is borne by you and moving into an arrangement where there are not any guarantees and ALL the investment risk is borne by you.
Where you choose to invest (once the money has been transferred) would depend on how you feel about investment & the associated risks.
First, what experience of investing have you had?
We need to explain the principles of risk and reward and the fact that usually the more risk you take the more money you can make but equally, the more you can lose – see Investment Volatility section below.
Within an investment what usually controls the level of risk you take is how much your new fund invest on the stock market e.g. company shares (shares are classed as a type of asset).
You can also invest in what are broadly considered lower risk assets – the main ones are cash, bonds and property. These can still go up and down too but usually to a lesser extent than the stock market.
If you have some experience – then you probably already understand these basic principles of risk versus reward.
Determining your invest risk category
We have a very simplified approach to determining someone’s attitude to investment risk.
There are many complicated computer programs that can be used to try and work out your attitude to investment risk and where you should therefore stick your money, however, the one thing that can be guaranteed about them is they all have faults and none of them are fool-proof.
We prefer to run through the following explanations, which we have found, over the many years we have used this method, provide an explanation that everyone can understand and allows you to invest appropriately for you and the level of investment risk you are prepared to accept.
These are the main risk approaches with a definition of each:
Some individuals may not want to invest in the stock market at all and can be lower than Cautious and invest into cash only – this is not risk free as inflation/cost of living can far exceed returns and it is not designed for investing for normally more than 1-2 years at most
Alternatively, you can also choose to invest in the lower risk asset classes only – this would usually fall under Property and Fixed interest – again this is not risk free – and investment choice is fairly limited in terms of asset type.
A typical cautious investor may only limit stock market investment to around a quarter (sometimes more). This means most of the money would be invested in what are broadly considered lower risk investments. The aim would be to try and outpace inflation. However, this could result in limiting the returns as it can be invested quite defensively.
Somewhere on the middle of our scale is what we would call our medium level of investment risk. This would mean having around half of the balance (again sometimes slightly more) in shares in the hope that it’s going to grow more than a cautious investment or significantly more than inflation, in exchange for the acceptance that the ups and downs can be more dramatic.
This is where an investor would start to prioritise growth over anything else and invest the majority in the stock market to maximise growth and not be phased by significant ups and downs as they would probably be investing over a long period of time (over 10 years) or they have ample retirement provision so they can afford more of a risk.
Equally, you may be experienced enough to invest in a specialist area or self-invest – this could include commercial property or your own 100% share portfolio.
Where would you put yourself on our scale?
Volatility is the variation in the rises and falls of a chosen investment strategy. It is generally accepted that the more risk taken the greater the volatility and therefore the greater the loss or gain, depending upon the timing of taking any benefits.
The purpose of the Investment Volatility Chart below is to give you a simple indication of the potential volatility of various investment categories, by looking at best and worst calendar year performance.
The period of 2008-2015 has been chosen because it includes two particularly volatile years (2008 and 2009) where historically high levels of loss and gain were recorded.
This graph aims to represent the relationship between risk and volatility moving from left to right (low to high risk). As displayed, an increase in risk usually means greater volatility:
Source: Royal London.
These returns are based on past performance, which is not a guide to the future, and actual future returns could be more or less than the best/worst years illustrated.
The general overview of what we are trying to achieve is to introduce how investments and risk work.
We need to help individuals so you can comfortably choose what suits you. Therefore, there is no right or wrong selection.
Bull & Bear Markets
Below is a graphic of the Bull and Bear markets history since 1900.
Notes: Calculations are based on FTSE All Share (GBP Total Return).
A bear market is defined as a price decrease of more than 20%. A bull market is defined as a price increase of more than 20%. The plotted areas depict the losses/gains ranging from the minimum following a 20% loss to the respective maximum following a 20% appreciation in the underlying index. Time period: 31 January 1900 to 31 December 2018. Calculations based on monthly data. Logarithmic scale on y axis.
Source: Global Financial Data.
Past performance is not a reliable indicator of future results. The value of investments, and the income from them may fall or rise and investors may get back less than they invested.
Issued by Vanguard Asset Management Limited which is authorised and regulated in the UK by the Financial Conduct Authority. © Vanguard Asset Management, Limited. All rights reserved.