Full Transcript

James: 0:47
What is up team? Welcome back to the Dennis who Invest podcast. This is the first episode in a brand new series on DIY investing, and what I’ve been meaning to do really since the inception of Dennis who Invest podcast was take all of this information that we have scattered throughout the different media outlets I suppose, if you want to call those the different portals of information, the different channels that we have and make it really chronological and easy to follow, especially whenever it comes to investing. So it’s super tangible, it’s super formulaic and it’s super systematic, and what it means is it’s way more implementable into your life and in that spirit. I’ve got Luke Hurley returning face from one of the podcast episodes, way back when episode number 40 ish, I believe which was on the NHS podcast. It was the second episode we did. It was the follow-up to the first one and it’s been way too long since we’ve had look on the podcast and really looking forward to getting into this one today and really doing exactly what Dennis who Invest says on the tin, which is to cover investing from the bottom up. So that’s why I’m really excited for this particular series.

Luke: 1:55
Yeah, thanks, james. Thanks for having me on. I’m really looking forward to the series on DIY investing and picking everything apart and, as you say, giving people a bit of a structure to work towards, so I’m really looking forward to getting started.

James: 2:09
Just makes it way more understandable, because I do have this information, maybe not just as crystallized as this and certainly not as formulaic as this, certainly is not as systematic as this is what we’re going to do on this series and then it just makes it way more easy to follow, which is flipping cool, and we can make real impact on people’s lives. First episode of many, first episode of many, for sure. So what we’re going to talk about today is investment risk, and from a very high level. I feel like risk is often misunderstood by many people. It’s one of the great misconceptions that there is out there about life on a holistic level and about specifically investing as well. The greatest risk of all is that we don’t invest. In my opinion, most people have the perspective that investing is a risky thing. Actually, if we don’t equip ourselves with this knowledge and what it means is, nothing will change and won’t stay exactly where we are Now. Here’s the thing you might be happy with your current existence, and that’s totally cool. Or you might be unhappy with your current existence, in which case it’s advisable to change. But here’s the thing whether we’re unhappy or not, or totally happy and content, we still have to make the correct provisions for that future version of our self, the future version of our self which will come around eventually when we aren’t able to work for whatever reason or whenever we decide that we just don’t want to work anymore. We get to choose. It gives us the option and in order to do that, we got to understand how we can set about the correct conditions in our life, which usually takes the form of growing our wealth long term and understanding investing so that we have that delicious pot at the end of our career which we can fall back on and ultimately have financial freedom.

Luke: 3:46
Yeah, agreed. I mean, we are the number one risk as human beings. We are the risk to financial success long term, blowing ourselves up by doing the wrong things at the wrong times for the wrong reasons, and so I think this is a really good topic to get started on picking apart investment risk and looking at how that plays out and how having misconceptions and not a full understanding of investment risk can really derail your long term plans.

James: 4:16
Well, we just got to flip risk on its head. We just got to flipping on its head. I think the riskiest thing of all is that we can accept some sort of compromised existence, and we’re not currently in that. We’re not currently happy in that. We’re currently exchanging time for money continuously, forever, and to me, not doing anything about that is the greatest risk of all, whereas stepping outside of that zone is stepping outside of that circle and understanding all the things that you need to know to be able to create your ultimate life, to be able to design your own version of financial freedom. That, to me, makes so much sense whenever you view it through that perspective, whenever you view it through that lens and understand that really, the greatest risk of all is not changing anything and then one day, finding ourselves in a position where we’re unable to work and we don’t have anything to fall back on, and that’s exactly the sort of stuff that we’re going to talk about today. Actually, the riskiest thing is that we don’t learn this stuff rather than invest our money, and we will certainly be delving into that in more detail in the next few minutes. So let’s talk about risk, specifically whenever it comes to investing, because there’s actually different types of risk whenever it comes to investing, and when we can categorize them, we begin to understand them and then, therefore, we can rationalize them right.

Luke: 5:25
Yeah, I think there’s hundreds of different types of risk that we could talk about. I think we’ve picked up five core risks or five main risks. So we’re going to start with provider risk, then talk about specific risk, then market risk, then inflation risk and then finally we’ll talk about shortfall risk. They have different terms for the same, ultimately the same concept, but we’ll use those labels for now and if we get started, maybe, on provider risk, I think that’s a useful starting point.

James: 5:57
We’ll do just that, and I remember when I learned about this way back in the day, whenever I was able to categorize the different types of risk that my portfolio was going through, then all of a sudden it wasn’t this just big, mysterious mess and I began to understand why certain things happened. And then I was like, oh, that’s just this manifestation of this particular type of risk. But I know that when I design my portfolio in such a way that actually I can virtually entirely mitigate that which is really cool and why it’s so important to be able to understand this because otherwise then we’re an emotional investor and emotions and investing never really end well, right. No exactly Cool. All right then. Well, let’s go ahead and jump straight in, and the very first type of risk you mentioned just then was provider risk, wasn’t it Luke?

Luke: 6:45
Yeah, for me, provider risk is probably the one that’s confused the most, and I think when people try and think themselves about investment risk, they often will confuse one of these many types of risks with another. So provider risk is really the, the organization or the or the business that is sat behind your investments, either managing those investments or you know, the company that has custody over your investments. They are you know. It could be a fund manager, it could be a platform provider, it could be an insurance company. It’s the product provider that’s sending you the statements through the post to give you updates on your investments. That is a risk, or they could be a risk if they were to struggle in some way, shape or form financially themselves. We saw during the financial crisis in 2008,. We saw runs on banks in Northern Rock, for example, where people were queuing up to get their money out, and I think as a result of that and the legacy of that is, people are concerned about how secure is my money if I’m putting a large portion of my wealth with one provider, and I think it’s key to address that first up 100%.

James: 7:59
So that particular type of risk. Here’s the cool thing whenever we understand what these risks are and we can categorize them, we can also address them and we can also understand how we can take steps towards mitigating them. So with that particular type of risk, look how do we minimize the potential for that to affect our wealth journey adversely.

Luke: 8:18
Well, I’d say, first up, the government does have a history of stepping in if a collapse was to impact on retail investors and on top of that, we are one of the most heavily regulated or have one of the most heavily regulated financial services industries in the world, so we have a level of protection there, thankfully, from the UK government. I think steps that you could take is any company that you’re dealing with, whether that be a fund manager, an investment advisor, financial advisor you should be checking that they are regulated by the Financial Conduct Authority, the FCA, which is the UK’s regulator, making sure that they have the correct permissions to give you the service that they’re offering. That’s quite straightforward that those firms, by law, have to publish the fact that they are regulated by the FCA. So you’ll see that terminology written all over there, their literature. But I think that’s the first step. I’d say the second step is making sure that your investments are held in a nominee, what’s called a nominee account. So that really means that your money’s ring fenced for your sole benefit. So if the firm that’s managing your investments falls into trouble, it comes in solvent. Then your investments would be protected from the firm’s creditors. It should not be on the provider’s balance sheet. So if your money is sort of ring fenced in a nominee account, then their financial solvency as a provider should not impact on the value of your investments.

James: 9:53
There we go. Yeah, we finish this then.

Luke: 9:56
Well, the final thing to say is just that we also have the financial services compensation scheme, which quite a few people are aware of, which is like an insurance, really for retail investors by retail investors I mean every just regular people, not institutions and that does kick in if there are issues albeit there are limits on that. It’s worth checking out the FSCS Financial Services Compensation Scheme website to check up on those, and they are limited in terms of the amount that you’re insured, up to typically 85,000 pounds, but that could change in the future and it is limited to different institutions. So if you’re talking about bank accounts, for example again, lots of people know this, but it’s the group as a whole. So if you had money with Halifax, that in the eyes of the FSCS is the same as having money with Lloyds, because ultimately they are from the same parent company, but it’s 85,000 pounds per person, so a couple would have 170,000 pounds. That is in place. But ultimately, if you’re going to a company that has a robust compliance process, has the protections in place for their investors, this stuff should not be an issue. I think where people confuse things is where you’ve got money with a bank and we saw the issues with Northern Rock, your money is a lot more tied up with the fortunes of the bank itself. With an investment platform or investment products, your money is not sat on their balance sheet. Your money is not going to be impacted by a product provider going in solvent. In fact, what would probably happen is the administrators would step in and they’d be looking to find a buyer for that distressed business. So a different company would step in and buy out their book of clients or of accounts, because they’d be interested in the recurring income that’s generated from the fees that that company is being charging. So I think there’s a danger of getting too hung up on this stuff. Lots of people have quite sizable sums of money on platforms, investment platforms. I myself have all of my money with one platform. It does not keep me awake at night worrying about the fortunes of that platform, and I think that’s worth bearing in mind.

James: 12:23
You know what, and I’m just going to chuck one thing on top of that the only way to totally mitigate that risk, as in reduce it to zero, is to keep all of your money under your flipping bed, right? But then you don’t have any access to all the amazing privileges and benefits of the financial service industry. So, whilst it’s about doing your due diligence, no, it’s important to remember that you can never mitigate that entirely unless you completely restrict your possibilities in life or you completely restrict the likelihood that you’re going to obtain financial income or financial freedom, rather. So that’s a very important thing to remember. That’s why I look at that, and it’s not like you can reduce any of these to zero unless you step outside of that zone, in which case you’re never going to benefit from all the amazing upside.

Luke: 13:12
Agreed and I think, just to reiterate, for me it’s riskier having large sums of money on deposit in a bank because of that added element than it is having your money on an investment platform, whereas in a separate nominee account ring fenced from the fortunes of that particular company.

James: 13:32
There we are Great stuff. Onwards to the next type of risk we are going to talk about today, which is specific risks. So getting a little bit technical here, look specific risk. What is that?

Luke: 13:48
Yeah, so specific risk. I think this is what most people think of when they consider investment risk, and where you hear people say I’ve lost money on the stock market, it’s usually because they’ve exposed themselves to too much specific risk. So specific risks are risks that are isolated to a particular company. If you buy shares in that company, a sector or a regional economy, and if you only buy the shares of one company, for example, then you’re taking on all the risks associated with that particular business failing. And if that business fails and you’ve only got your money invested in one business, then you could lose all of your investment. So Putting all and the same applies actually from a sector position. If you put all of your money in tech stocks, for example, then you’ve got all of the risks associated with one particular sector. So the key thing there is is to understand that specific risks can be mitigated. You can do take steps to Really reduce your exposure to specific risk.

James: 14:47
Sometimes I come across people and they tell me that their entire portfolio is in Amazon and it’s done really, really well up to this point and I’m like, yeah, it has yeah. But here’s the thing just because it’s doing well Doesn’t mean that they might and continue to do. It might continue to go that way and as well as that. If Amazon, for whatever reason, went bust, you know, I’m sure they would take steps to bail it out, etc. But the world would keep turning. The world would keep turning right. It’s very important to remember that that can go really, really, really well for like 30 years and then all of a sudden Not, and the entire portfolio is gone, so that those types of portfolios are way too over leveraged in specific risk, in my opinion, and people will use their historic gains as proof that they’ve made the right call and I see people do that all the time. The important thing to remember is that if that company, there is the potential that that could fail, there is the potential that you could lose your entire portfolio overnight, whereas when you diversify correctly amongst many companies across the world’s economy, yeah, you might get, get, might and get as big returns as whatever Amazon’s got over the last 10, 15 years. However, when your portfolio is suitably diversified, then what it means is that the only real way your portfolio can be sunk in that instance Is if the world’s economy ceases to exist, and that is a way bigger deal than Amazon filling and way, way, way, way way, infinitesimally less likely.

Luke: 16:11
Yeah, there’s also just worth mentioning as an example, lots of people where they have share schemes for their employers is a prime example of people Unintentionally taking on lots of specific risk. So, in the financial crisis, to go back to that, all those that work for financial institutions work for the banks. Lots of them had shares in their employers. So if you work for one of those big, big, big banks that fell into financial difficulty, quite a lot of people had a huge amount of their wealth invested in their employer and didn’t think about diversifying away that, those specific risks and, as a result, they lost significant amounts of money. If they, if they crystallize those losses. So, yeah, for me, specific Ross, specific risk is is right at the top of them, of you know, the of the Of the pyramid, if you like, in terms of things that you can control and you can deal with and and it’s quite a simple one to actually mitigate through basic diversification. And we talk about I mean the, the elevators. If you’ve got two elevators, one with one cable and one with five, five cables, which one do you want to get into? It’s the one that you’ve got, that you know. You’ve got five cables and the same price for investment portfolios. If you’ve got all of your money invested in one share, then you’re taking an awful lot more risk than somebody that’s Got their money diversified and spread across different different companies.

James: 17:42
One thing I’d like to add to that before we move on. It’s the amount of headspace that that style of investing consumes as well. And what I mean by that is, say, you have a lot of your money in a big individual company. Therefore you’re overexposed to a specific risk because your whole portfolio is allocated to that one entity. Then think about it like this right, when you check that portfolio, when you see it going up and down, they’ll always be in the back of your mind Should I sell or should I continue the way I am? Should I buy more, whatever right Now, that’s always going to be the case when you’re investing in individual companies, because there is no. They’re not fundamentally, intrinsically tied to the world’s economy, like some suitably diversified funds are. Therefore, there’ll always be that decision in the back of your mind when do I cash out? Right, and I used to do this back in the day. And, yeah, you can get some really good gains on paper Over certain time frames. But if your goal is to grow your money long term and to not allocate any Headspace to that whatsoever in so far as not allocating your attention to your investment portfolio every single day, you just want it to grow in a truly passive way, then diversifying is the only real way that you can allow your portfolio to be able to grow, to be exposed to gains, to be exposed to the continuous rise and growth of capitalism, without also devoting a lot of your headspace to it as well, particularly if that headspace is going to be more valuable in other areas of your life which will allow you to gain greater returns, like, say, day to day or running your business and things along those lines. The headspace factor is massive.

Luke: 19:18
Agreed. If you want to build a sensible, low maintenance, long-term investment portfolio, then you know the obvious thing to do is to spread your portfolio across different companies, sectors and geographic regions, and then you don’t have to worry about that stuff. You just put your portfolio in autopilot and go about living, living life.

James: 19:38
And the only reason why that came to mind when you were talking is because I’ve 1000% been there and there’s someone who used to do that and who’s now seen the light on doing it in a passive way, in a more hands-off way, I can tell you you actually think about it way less, but certainly that was the. That was the conclusion that I arrived at in a roundabout way. So if we can save someone that journey by listening to this podcast today, then that is obviously a very helpful thing. Look anything more you want to add on that before we move on to the next thing.

Luke: 20:06
No, I’d say that, um, I mean, there are funds, just to put that, add a bit more context. There are funds out there that you can Invest into where they will, for you, spread your money across thousands of companies, for thousands of shares, bonds, etc. So different countries, markets and sectors, and for me, that level of diversification is how your beginner investor can Focus on investing rather than speculating. And I think where lots of people Fall into those misconceptions of investing is is like gambling. Um, actually it’s not. If you, if you’re investing long term through a low maintenance portfolio, using funds, collective investments, where your money is spread over thousands of companies, that is not the same as as gambling. Um, you’re diversifying across those risks and you are embracing, as you said, you are harnessing the power of of capital, capital growth compounded over over a number of years. So, just to recap, we can diversify away specific risks and the price of one share can drop to zero, but thousands of shares aren’t going to drop to zero all at the same time, and the long-term investor Sets the rules of the game in such a way that they can only win. So if you can diversify away, uh, your specific risk and by doing you know to do that, have a stake in every single major company around company around the world. Um then you’re protecting yourself from from unnecessary Risks to your, to your portfolio and to your long-term success.

James: 21:33
Beautiful stuff, and you know what the cool thing about specific risk is? That it segues very nicely Into the next form of risk that we’re going to talk about, which is market risk. Because even though you might have a suitably diversified fund and you might admit it, you might have minimized the impact of specific risk as much as possible on your portfolio, there’ll always be a degree of market risk, right Look?

Luke: 21:54
Yeah, you can’t diversify away market risk. It’s, it’s just the nature of the beast. It’s, it’s how you actually, in many ways, is how you get your returns. It’s and it’s how you respond to market risk. That’s going to be the biggest driver of your long-term success. So the key really here is just to not confuse these different types of risks, which is really key for us to break these down. But market risk is the risk that the value of an investment will decrease due to a geopolitical and macro economic factors and, you know, elements that are going to impact on the entire market for example, a recession, a stock market crash and our response to that is or Our natural response to that as human beings, is to be fearful, and if we’re fearful, we’re more likely to sell our investments at the wrong time and crystallize what would otherwise be paper losses. So it’s really important to understand Market risk. Really, what that means is short-term volatility. That does not have to be something to be scared of or afraid of. It’s actually something, in many ways, that is something that you should embrace as a long-term investor.

James: 23:00
And there’s a really pertinent recent example of this right as we recorded in 2023, that example being the war in Ukraine right.

Luke: 23:10
What then then? That? Yeah, exactly that. And and the pandemics another example of that they go. Markets dropped for three months. If you panic to that time and soldier investments, you would crystallize those losses. If you just sat tight and didn’t react, you you’d have been back in the black in in quite a short space of time. So there’s some key points I’ve written down here on volatility. So the first one is volatility cannot be diversified in the same way that specific risk can. So markets bring Uncertainty and at various times people lose confidence in the markets and they rush to sell their investments. But in moments of extreme panic, investors don’t make distinctions about different quality of companies, they just sell the lot. They panic and they sell everything when in reality the, the fundamentals of those businesses that you’ve invest, invested into, quite often they will not have changed. So if you invested into the right things with the right reasons, those Know those, those core Benefits of those investments shouldn’t have been impacted by short-term market movements. This the second point I’ve written down is volatility is not the same as loss. Again, we’ve we’ve kind of made that point. But the biggest mistake, most common, the biggest common mistake people make is to confuse market volatility with permanent capital loss. So if you invest 10,000 pounds and one year later your statement says it’s now worth 12,000 pounds, you feel great. But if the following year your statement says the value is 8,000 pounds, you feel pretty miserable. But the fact is you haven’t actually lost anything. It’s just the value of your investments on a piece of paper that’s changed and if you leave it to run the long term, it will, using history as our guide, regain its value, and until you sell your investments and receive the cash back for them, the value is really theoretical. The third point I’ve written down here is that volatility is normal and it’s to be expected. So when any market falls by at least 10% from its peak, it’s called a correction, and when a market falls by at least 20% from its peak, it’s called a bear market. I think the, the news, the media outlets make all of this sound extremely dramatic when it happens, but the reality is its routine. So when there’s a stock market decline or a temporary market decline, a drop in the values of of markets across the world, the, the the news outlets get extremely excited, but in reality, on average every year, there’s a decline from top to bottom of around about 14 15%.

James: 25:41
In my experience, it’s the short-term volatility that that is the thing that puts most investors off being able to harness the power of capital markets, because they think that whenever something goes down in value, particularly really, really, really good assets that have consistently went up in value since creation that is the thing that puts people off investing this, because they think that that downward trend, they think that this is it, everything is over. I need to get my money out as quickly as they can, whereas if they just look back on historical data, they would see that there is, it’s been something that’s happened before, and this is all part of the journey.

Luke: 26:19
Part of the journey and it’s temporary. Volatility is temporary, it’s natural. It’s normal. It’s unavoidable. Stop market crashes occur with surprising regularity, but they never last, and that’s that’s the key thing to understand that the market itself has never taken a penny from anyone. It’s the human beings and how they react To the stock market that loses money.

James: 26:43
Which is why it’s so important. It’s so important that we talk about all these versions of risk, because when you get this stuff, then what it means is you can just rationalize what’s going on and then, therefore, you can understand that actually, the biggest reason why most people are not successful at this stuff is not the asset that they purchase, but their own reactions to the behavior of that asset.

Luke: 27:03
Most of the time, yeah, absolutely, and I think the the next thing says that volatility is compensated long term. So that’s Probably the biggest takeaway, or the biggest thing that people need to understand is you are actually rewarded for your patients, and that is why Volatility is so important to long-term investors. That is what you’re getting your return for is your ability to sit through those temporary market declines. That’s going to give you your long-term return.

James: 27:31
Really cool way of looking at it. So there’s some data out there that says that the market let’s, let’s, let’s call him the market, the American stock market, just for just for ease or simplicity. Today the American stock market has went up in value eight out of ten years. So even if you just roll, if you just flip a coin, if you keep betting the same amount of money and flipping a coin Right, and eight out of ten times you win right. If you just keep betting the same amount, you’re going to win right. You’re going to win right. Naturally, there’s going to be some losses in there as well, yeah, however, if you’ve positioned yourself correctly, then what it means is is that overall, you’ll continuously win. What most people will do is They’ll flip the coin ten times, they’ll win six times and lose the seventh time, sell everything and because at that point, the volatility might have meant that there was such a huge temporary loss that all that good work is negated at that stage, whereas if they would have just continued, they would have been good. However, I feel like that partly comes from not understanding all of the stuff that we talked about today on this podcast and we’ll continue to talk about over the next few minutes and From people making those decisions from an emotional basis and not a rational, logical one. That penny flipping example really, really, really helped me understand that.

Luke: 28:46
Yeah, and the UK stock market is actually the same and the global stock market one in four years. Historically, canada years have been negative. Three and four years have been positive. So the rational investor is just going to sit through those one in four bad years and then benefit from the three and four good years, and that’s how you get rewarded as a long-term investor. How you lose money is by panicking and selling your investments during that, during that downturn.

James: 29:11
Lovely stuff. Okay, anything you want to add on top of that before we move on, look.

Luke: 29:17
No, I mean the. The irony, of course, is that, for the long-term investor as well Particularly with somebody that’s paying into their investments on a regular basis you do not want your, your, you do not want this. The stock markets Suddenly race away when you’ve just started your investment journey, or even if you’re midway through your investment journey, because you’re just buying the same assets at a higher price. You actually want the stock market to be as low as possible for as long as possible, for things to be quite bleak, so that the price of what you’re buying is Cheaper, in the same way that if you wanted to go and buy something from a the department store and the sale was on, that’s the right time to buy, and it the same. The same principle applies when you’re investing your money. You want the market to be low Whilst you’re putting money into your investments, and then you want it to rally when you want to start drawing on those investments. So volatility itself actually presents opportunities and should be embraced by the long-term investor as as a as a positive thing. Your money is going out there into the market and buying more of those assets that you’ve identified as being worth Worth what worthwhile buying and allowing you to to build up a portfolio for the long term 1,000%, and because most people don’t think like that.

James: 30:28
That is why most people struggle to execute this stuff. There’s some mental jiu-jitsu that you have to put yourself through at the very start to be able to really Understand that term and internal understand what we’ve just talked about, it We’ve just talked about, and also internalize what we’ve just said. However, when you do, you become powerful, because then you see that these downturns are actually Opportunities. Let’s move on to the next risk, which is inflation risk. This is the one that caps people out. This is the one that everybody is exposed to without realizing it and Whenever they don’t understand investing. What it means is that your portfolio and your wealth is constantly being eroded by this effect. Therefore, not only can we do something about it, we must do something about it, particularly if we want to be financially free. We have to understand that it’s occurring. First of all, that was one of the biggest mindset flips about investing for me, when I realized that if I don’t do anything, I’m actually still not safe. I thought the safe thing to do was to just not do anything and not be involved in the markets whatsoever.

Luke: 31:28
Not the case yeah, I think Arguably inflation is the number one biggest Risk to your long-term wealth. If you don’t understand it and if you don’t take action to protect yourself from it, then it really has the ability to Arrive your a road, your wealth over the long term. If you’re not prepared and you know, you know You’re not actually proactive in in making your money work hard enough- Boom, so inflation risk.

James: 31:55
How does that work? How does, how does that affect us day-to-day look?

Luke: 32:01
So just the general increase in prices or the cost of living over time, if your money is, let’s say we’re just giving an example, so the one I always use is the cost of milk. So in 1917, 2.4p would have bought you 2.4p, whereas in 2017, 2.4p would have bought you 2 tablespoons of milk. That’s just the fact. We live with inflation. It’s the nature of the system, the economy, and that’s fine. But if the assets that you’re using or where you’re storing your wealth is not keeping pace with inflation, then you are essentially losing money in real terms. So the purchasing power of your money, where you’ve stored it, is actually reducing.

James: 32:45
Do you think to understand that, even though the figure is staying the same on the bank account screen, that actually the real value of what that can be exchanged for is continuously going down and down and down? And that is a process that happens against our will, without our consent, and there’s a whole host of reasons why that occurs, which we can discuss in greater detail in another podcast. As to the nature of money and how, there’s some fundamental principles about money which mean that inflation is always inherent to the system. All you need to know is that it’s inherent to the system and that we’ve got to do something about it because it will catch us if we don’t understand how we can grow our wealth long term. That’s why the greatest risk of all is staying exactly where we are. In my opinion, that was the biggest mindset flip for me, and actually the way that will allow us to have the least risk in a strange way in our life is when we understand how to grow our wealth and we understand how money works.

Luke: 33:41
Yeah, and in simple terms, if inflation is 10% and your money is in a bank account earning you 5%, you are losing 5% a year in terms of the purchasing power of that money. And from what you say as well, let’s love a bit of inflation. They can add money to the system, keep the economy ticking along and don’t necessarily have to explicitly raise taxes or cut spending to do it. So in many ways it’s a hidden tax.

James: 34:07
It’s inherent to the system and it’s also part of the reason why assets tend to outpace inflation over long periods of time and we can save that for another podcast now. Then we’re getting into financial theory and economics at that point. But when you understand that inflation is real and it’s consistent, then actually in acknowledging that we’re also to a degree acknowledging that assets outpace inflation generally speaking, and there’s a variety of reasons why that occurs. So if you simply accept that it’s real, then actually you’re also indirectly accepting that you can grow your wealth when you understand how to take advantage of that principle.

Luke: 34:45
Yeah, and historically, the best asset class for protecting one’s wealth against inflation has been global shares. That’s just fact If you look at the data and you look at the history of it. So what should the rational investor look to be investing in as part of a well-diversified portfolio? Certainly those asset classes that are going to protect you from inflation risk.

James: 35:09
Boom. There we go, luke. We’re going to move on to the final type of risk we’re going to talk about today, anything you want to throw into the mix when it comes to inflation risk.

Luke: 35:19
just to round things off, no, I think inflation ties in with what we’re just about to talk to, which is shortfall risk, which is the idea that it’s like a personal risk to the investor that they don’t fulfill their financial objectives because they’ve not taken action or they’ve not invested in a certain way or they’ve not taken on enough market risks to achieve the returns that they need to fulfill their financial plan.

James: 35:47
Absolutely so yes, let’s jump straight in with shortfall risk. Anything more you want to add to what you’ve just said?

Luke: 35:53
No, it’s a risk that portfolio doesn’t generate the growth required to achieve your goals. So the biggest one, obviously, is that you run out of money in retirement, in traditional retirement. So not saving enough for retirement, not putting enough money away that is really shortfall risk. And not having a suitable, well-thought through financial plan where you’ve identified the amount of money that you need in later years and you’re setting aside the correct levels of investment to achieve that long-term objective and you’re investing in the right asset classes to give you the growth that you need to reach those targets, that really is the heart of shortfall risk.

James: 36:40
Well, this is it, and this is the most common thing that certainly you’ve seen and I’ve seen amongst people that we talk to you and that is that they have investment portfolios. They’re very young people and they have investment portfolios which are over leveraged in bonds. The idea of them having a greater bond allocation is that they are adjudged to not be someone who wants to have an excessively volatile portfolio. Therefore, they’re over leveraged in bonds. Their portfolio isn’t as volatile. However, it’s not going to get the returns that they need to be able to obtain financial freedom at a point where they would otherwise do it much sooner if they understood a lot of the stuff that we were talking about today, and there’s a whole host of reasons why that happens, so that’s certainly a common one to watch out for.

Luke: 37:32
Absolutely so. Risk and return are correlated, and by risk I’m talking about market risk volatility. You’ve got cash at the bottom, it’s low, there is no volatility, but you’re going to get the lowest level of return. You’re not going to be compensated particularly highly for keeping your money in cash. Traditionally. I know interest rates have gone up in recent times, but historically it’s at the bottom in terms of the long-term return that it’s going to give you. Then you’ve got bonds or fixed income, fixed interest. Then you’ve got property and then you’ve got shares. So shares are at the top of the list in terms of high volatility, but potentially high long-term returns if done sensibly. So shortfall risk is about understanding how you should construct a portfolio to achieve your long-term financial objectives by mixing those different asset classes together, which is certainly something that we’re gonna cover in a separate part of the series. If you don’t do it properly and you, by trying to be potentially too conservative and putting your money in those asset classes that historically have delivered lower long-term returns, when you factor in inflation, you expose yourself to the risk of not necessarily achieving the level of wealth that you could have done if you’d grasped these concepts and put in place a better long-term investment strategy.

James: 38:58
Worth mentioning as well that there is a place for assets which are less volatile in our portfolios when we’re coming closer and closer to financial free our retirement date, or financial freedom date, I suppose, if you wanna call it that it’s worth noting that it is worth divesting out of more volatile assets which are orientated towards growth. When it’s growth, when it gets closer and closer to that time. However, certainly at the very early stages of our investment career, we wanna prioritize growth.

Luke: 39:27
Yeah, exactly, we’re gonna do a whole section on talking about asset allocation and how you should blend those different asset classes to benefit from the different characteristics. As you say, if you’re looking at, I always think of it in terms of defensive assets and offensive assets. So defensive assets are those, like bonds, that are gonna dampen down short-term volatility. So if you’ve got a short-term time horizon, they certainly have a place in your portfolio. If you’ve got a long-term time horizon, then really do I need the emotional comfort that bonds are gonna give me by dampening down my volatility. Is it worthwhile? Because by dampening your volatility you’re also gonna dampen your returns. So if I’m a long-term investor or a rational long-term investor, that for me does not make sense. But the key there is understanding investment risk, which is why we’re doing this podcast. But if you have that understanding, it really puts into perspective those different decisions when you come to build a portfolio and the asset classes that you use.

James: 40:23
It’s so important to understand this stuff because these are the most common things that people don’t always get. These are literally the things that will allow you to be financially free at a much sooner date and get the most out of your investment portfolio. Whenever you grasp these concepts, education is the key, and that is the message of Denys soon invest, and that’s why it’s particularly interesting that we’ve created a learning platform together on this exact thing, which is called Denys soon invest Academy. For anybody who’s listening to the podcast, anybody who has listened to this content today and find it useful. There is a ton more stuff along these lines which will allow you to be able to make amazing investment decisions. We’ll be able to find it in the description, so feel free to check it out. At the description of this podcast, look. Anything you’d like to add?

Luke: 41:07
No, I mean obviously we’ve put a lot of work into the platform and it’s got everything there that you need to know and do to be a successful DIY investor.

James: 41:16
Great stuff, guys. It’s been absolutely amazing to create this podcast today. This is the real juicy stuff that embodies the true message of Denys soon invest. There’s going to be way more where this has come from in the coming weeks to months. I’m looking forward to it. Please let us know if there’s anything that you’d like us to cover in particular. These will be the things that allow you to understand investing, grow your capital at the greatest rate possible and do it sensibly, of course, in a way that is aligned with long-term data, and then also, as well as that, accelerate your journey to financial freedom. Luke, it’s been an absolute pleasure to have you on today. Anything that you would like to say in conclusion?

Luke: 41:56
No cheers, James. Thanks for having me on Looking forward to the rest of the series my pleasure, Thank you.