13th September 2012
This is the question posed on the Systematic Relative Strength blog, which quotes a survey showing that young investors now have a lower risk tolerance than their elders. Given the challenge Generation Y-ers face in catching up with the Baby Boomers this latest research is concerning.
What's the problem?
The risk/reward tradeoff lies at the heart of portfolio construction. In essence the concept suggests that the higher the risk inherent in an investment, the larger the potential return (and vice versa). HSBC defines it as follows:
"Low risks are associated with low potential returns. High risks are associated with high potential returns. The risk return tradeoff is an effort to achieve a balance between the desire for the lowest possible risk and the highest possible return. The risk return tradeoff theory is aptly demonstrated graphically in the chart below. A higher standard deviation means a higher risk and therefore a higher possible return.
A common misconception is that higher risk equals greater return. The risk return tradeoff tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses."
This may not be very reassuring, particularly for those who have lived through the Dot Com boom and bust as well as the financial crisis. After these traumatic events it is understandable that phrases such as volatility and risk have become synonymous with the darker side of the financial services industry.
Given the parlous state of the job market and a tightening lending standards, however, there is a very real risk that the lifestyle aims for the young generation will be frustrated unless they are given proper guidance. Things that were taken for granted by the previous generation, such as home ownership, may be kept out of reach as savings are put towards rent or eroded by inflation as they sit in the bank earning historically low levels of interest.
Furthermore it is precisely younger investors, who can invest money for the longer term, who should benefit from the risk/reward tradeoff. Faster growing emerging markets, for example, may not offer the stability or predicatability required by pensioners but they should provide higher returns over the decades ahead.
If it is true that those under 35 are now more risk averse than those aged 49 to 64 then it would seem that trust in conventional investment wisdom has been breached. Though for many it may seem that financial markets have been tainted by recent scandals, ignoring them could also come at a cost.
The generational challenge
It may be tempting to blame younger people for their lack of interest in investment but this ignores the signals sent out by the industry. A number of financial advisers would turn away people whose incomes fall below a certain level, while regulatory changes towards upfront fees may scare away those who do make it through the door.
Yet this is a problem that is unlikely to go away. These same people who have lost trust in the financial services industry will ultimately be those that advisers will have to target. Leaving it too late could be costly for all involved.
Some believe that the answer to this dilemma is technology. For example American company WealthFront describes itself as "online financial advisor catering to the young and tech-savvy Silicon Valley community". It manages investments of as little as $5000 through model portfolios that are built around perametres such as the client's age and the amount they earn.
Nick Cann, Chief Executive of the Institute of Financial Planning (IFP) which counts over 2000 financial planners among its members, is supportive of the idea that online technology can help to bridge the gap between young people and the industry.
"I think it's encouraging that things are coming out to help retail investors but you have to be able to understand what the motivation is behind them. Without shrouding the market with obstacles the regulators have to ensure that there is clarity about what these sites are trying to achieve," he says.
"As an industry we need to call for a review of standards with regulators being more proactive about finding solutions. They've always regulated against conflicts of interest, which is important, but we should be working with them to benefit consumers."
Edging towards a solution
Websites that offer a click-and-play solution to investing may start to unwind some of the stigma attached to investing but they must also tackle the education gap if they are to become long term solutions.
The purpose of a financial adviser is to help an individual work out their priorities and invest their money in a way that will give them the best chance of achieving these goals. This is a dynamic not a static process and should be regularly updated to keep track of any changes in circumstance or one-off need to release capital.
As such railroading people into model portfolios may not provide enough of an explanation of why young people should invest. Taking on the risk of investing can and should only be done with the understanding of where they want to end up.
The message that needs to be sent is a very simple one: investing your savings offers you a better chance of achieving your life goals than leaving it in the bank. At present it is clearly not one that is getting across.
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