Are these the only risks? No, there are obviously many others, such as liquidity risk and currency risk, but volatility and inflation are the key risks and those are the ones that are dealt with primarily through the concept of asset allocation. Let us look at each of them in turn.
Volatility is all about market movements up and down. Stock markets do not generally go up in a straight line. They go up and down on a day-to-day basis, and even on a minute-to-minute basis, and prices of stocks are influenced by huge number of factors including economic, political, financial and the markets themselves. The price of a particular stock will depend at any time on the demand and the supply of that stock. If the demand increases and the supply stays the same then the price is likely to increase but if the supply stays the same and the demand falls then the price of the stock will fall until an equilibrium between supply and demand is reached.
During this first decade of the millennium there has been unprecedented volatility in markets. We saw a deep downturn in stock markets from 2000 until April 2003 and a significant rise in markets up until 2008 and the Lehman Brothers-induced crash. Markets fell significantly again throughout 2008 and most of 2009 and even in 2010 we have seen significant short-term volatility. (May be able to get a chart for this). The key word here is short-term. Volatility is generally a short-term phenomenon and, over the medium to longer-term, stock markets will always or nearly always rise at least in excess of inflation. Because volatility is so dramatic and newsworthy it is seen as the key investment risk but the reality is it is only a risk if we then actually need to realise our investments in a downturn and here we begin to see the first principles of asset allocation coming through, namely that we must cover short-term cash requirements with low risk investments, which are, therefore, low volatility investments, and that has to be a fundamental principle of financial planning.
The other key risk is inflation; we all know about inflation, we hear the inflation figures come out every month and we see the prices of goods and services rise regularly. For many of us the price of food, in particular, has increased significantly over the last year or so but generally inflation is a long-term risk. Central banks like to see a certain amount of inflation in the economy, normally around two per cent to 3.5 per cent, which is enough to generate above-inflation growth in the economy and, more importantly, provides a buffer against the far greater threat of deflation where prices continuously fall, people stop buying until they reckon that the price has fallen as far as it was going to and the economy suffers as a consequence. Generally we live in an inflationary world rather than a deflationary world and nominal assets such as cash and bonds will lose their real value in inflationary terms over the longer term, especially if interest is withdrawn. Inflation is an insidious risk; unlike volatility where you can see markets rise or fall by two per cent to three per cent on a day, inflation tends to be at rate of two per cent to three per cent a year and so it is easy to ignore but over the longer term inflation will do huge damage to a portfolio and that is why it is important to put that element of the portfolio not required to cover short-term cash requirements into real assets such as equities and property which, over the longer period, have traditionally always maintained their real value over inflation.
So in asset allocation terms what we are seeing is the concept of developing a portfolio that does two things. First it ensures that cash is always available to meet your own requirements irrespective of market volatility, and second it ensures that, over the medium to longer term, the portfolio maintains its real value after inflation and this helps to achieve the two most common financial objectives of an investor, namely to have sufficient funds available at any time to spend and to see their capital preserved in real terms over the medium to longer term.
In future articles in the money section we will be looking at some of the core pillars of financial planning, many of which deal with the whole concept of investment risk, volatility and inflation and so it is important to have this background before moving on to fundamental financial planning concepts.