Moderate investors: Two case studies

It’s time to wrap up our case studies by examining those who are in between the conservative and aggressive ends of the scale: moderate investors.

Having analysed the ends of the risk scale through the eyes of Luka and Angela (Aggressive Investors: two case studies) and Phyllis, Jack, Shirley and Gotye (Conservative investors: two case studies), we now turn to those – the majority – who sit somewhere in the middle.

The term ‘moderate’, apart from being uninspiring, refers to a transition range from aggressive to conservative. In other words, it’s not a defined point halfway between the two.

As most of us move through life (and financial capacity), our position on the risk map moves. Typically people become more conservative over time, as their time horizons shorten and their future earning capacity falls. But it could go the other way if, for instance, experience increases your psychological capacity for risk.

Like steak orders, we could carve up this ‘in-between’ risk zone into further gradations like ‘conservative-moderate’, ‘aggressive-moderate’ and even ‘slightly more aggressive than conservative-moderate’. But the important thing is to recognise, in a broad sense, where you sit on the spectrum.

Now let’s tackle the moderate zone through the eyes of some familiar friends.

Lucy and Luka

In Aggressive Investors: two case studies we met Luka, a man at the frontier of aggressive investing. Five years later, Luka is 37 years old and has married Lucy, who is a partner in a global law firm.

When they met, Lucy had a house. Together, they’ve paid off the mortgage and managed to create a $500,000 self-managed superannuation fund (SMSF) by merging their previous individual funds and adding a few nice lumps thanks to performance bonuses received by Luka.

On top of these more traditional elements of wealth, Luka has share options in his employer, a software company. These can’t be exercised for a few years and their value at that point will depend on the business’s performance – but if it keeps going the way it is, the options could be worth several million dollars.

He’s not a billionaire yet but life’s been good to Luka. And he still has a decent chance of making a lot more money given his rising seniority in the company and industry. Lucy has been just as successful but the grind of being a law firm partner is taking its toll. She’s thinking about taking a long break and kids might also be on the agenda.

With a decent bank of savings, a home and the possibility of kids, Luka’s position has changed dramatically. While he’s still got plenty of human capital, his financial capital (combined with Lucy’s) is a far bigger part of the picture than it was previously.

Luka’s psychological appetite for risk hasn’t changed much but, from a financial perspective, it’s time to become more conservative. They don’t need to over-react by moving to a portfolio stuffed with cash and term deposits but they should be commencing the transition to a more moderate portfolio. Chart 1 shows Lucy and Luka’s combined position on the risk map.

Luka can reasonably expect even higher rewards from his regular salary and performance bonuses (his human capital), so they don’t need to aim for stellar returns from their investments in order to underwrite a pleasant lifestyle. And the uncertainty surrounding Lucy’s future and their life plans means they should be easing off the accelerator a little. Effectively, they need to put in place a ‘base line’ for their financial capital (refer Chart 2).

Most of us should get more conservative as we get older. Lucy and Luka are a typical example of this.

Sean the school teacher

Sean is a 45 year old primary school teacher and a single dad with one child. Sean has no experience in financial matters and is nervous about making mistakes with his superannuation (he has no other assets except his family home, the mortgage on which he is 11 years away from paying off).

Even without any financial expertise, Sean can see that if he leaves his $140,000 superannuation balance in its present ‘conservative’ investment option, it’s unlikely to fund a comfortable retirement.

On the risk map, we can see that both Sean and Luka end up in the ‘moderate’ zone but that the limiting factor for each is different: Sean’s financial needs should cause him to take as much risk as he can stand psychologically, while Luka and Lucy should let their growing financial capital rein them in a bit, even though their psychological appetite for risk and their potential earnings remain high.

Chart 3 shows Sean’s position on the risk map. He’s not psychologically ready for aggressive investing but he’s out of the conservative zone by virtue of his financial situation.

Chart 4 shows Sean’s range of potential outcomes. He’s still likely to fall short of the amount he’d like to have to fund a good retirement lifestyle but moving any further out on the risk map (to open up the possibility of higher returns) would bring too much risk.

If his superannuation investments took a sharp dive (say, more than 15% in any year), he’d likely suffer an unacceptable level of psychological stress or, even worse, panic at the low point and switch back into conservative investments – thereby locking in any losses rather than riding out the bumps of higher growth investments (which he still has time to do).

Yet, by shifting further out on the risk map than his current ‘conservative’ stance, the range of outcomes for Sean becomes much wider. A moderate approach to investing is a smart move for those like Sean who don’t have the stomach for volatility but whom, from a financial perspective, need the growth that can only come with venturing outside of cash and fixed interest investments.

Other moderate investors

Most of us will sit somewhere on the moderate scale, especially once we’ve built up a bank of savings. Many of us don’t have the stomach, financial capacity, time or experience to opt for an aggressive (high growth) portfolio. And that’s just fine. The worst mistakes arise when people allow their financial goals to drag them too far out on the risk map. They’re then psychologically exposed when the next downturn arrives and are at high risk of making the costly mistake of selling at the bottom of the market – compounding their original problem of not having sufficient financial capital by locking in losses.

This is not just theoretical. Chart 5 shows how Australia’s SMSFs were more conservatively invested after the global financial crisis than they were before it: a mistake that we can all see the magnitude of with the benefit of a few years passing.

We can see that SMSFs were either too aggressively invested before the crisis, or too conservatively invested after it. Either way, this error cost Aussie investors billions of dollars – an asset allocation mistake from which many won’t fully recover.

Similarly, with extended life expectancy and working lives, many people whose savings sit largely in term deposits actually have the financial capacity to invest more aggressively than all-out ‘conservative’.

When the price is right, it’s wise for most of us to invest more in riskier assets so that our wealth grows over the long term, fending off the ravages of inflation. Counter-intuitively, ‘conservative’ investments like cash and term deposits are, in the long-run, a very aggressive (or high conviction) view on there being low inflation.

Summary

Such matters are getting firmly into the realm of asset allocation, which is the subject of our next few articles. We hope this series of case studies has helped clarify your own thinking about the different elements that go into determining your position on the risk map: your financial and human capital and your psychological profile.

After developing a good understanding of where you sit on the risk map, it’s time to think about which assets you should be invested in and in what proportions. That’s next week’s task.

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