Why are low risk investments so strongly advised for first-time investors?

Question

Inspired by the flurry of questions on this site about the returns available from investing in equities over the long term, I decided to approach my UK bank about setting up a small investment fund, built up by a modest monthly contribution of £50.

I am naturally quite risk-averse when it comes to money, but I can afford to gamble with that kind of sum. Besides, on investigation, it is clear that over the long run, these funds do offer fairly impressive gains. The high-risk option offered by my bank, for example, has gained 42% over three years.

After meeting with the bank, however, I was essentially told that they would refuse to invest in a high-risk fund for a first-time investor. This is in spite of the fact that I'm happy to risk the sum involved and happy to leave it over the long term where trends suggest it is almost certain to do better than inflation.

The fund they suggested has a much more modest 16% return rate over three years. If anyone wonders, I'm only quoting three-year returns because that's how long these products have existed, so further data does not exist - the same bank shows good five-year returns on other products, and I was intending to invest over ten.

Of course, as the customer and I could insist on getting what I want or I could take my business elsewhere. But it gave me pause for thought because I couldn't understand why - and the person I spoke to couldn't give me a good explanation besides "experience" and "policy".

I wondered if it might be because I have limited liquid assets - instead, my cash is sunk into a property which I fully own and which yields rental income. That's where I sunk all my savings because in case of dire emergency I have always felt I could simply borrow against it and then seek to sell to repay the debt.

Presuming that logic is sound, why am I being advised to steer away from more fruitful investments for a sum I can afford to lose?

Answer 1

First-time investors, quite frankly, do not have enough experience to accurately assess their risk appetite. You're willing to "gamble" with that £50/month, but that's because it's just £50, and you're understandably salivating over that "42%".

That wears off. Over time, you'll be investing £thousands. (In ten years, you'll have put £6k of your own money in.) And the more you've accumulated, the more your "naturally quite risk-averse" inner self will start to take over, because it's no longer just a lottery ticket — it's an investment, that you've put a lot of money into and don't want to lose. But that +42% can fluctuate wildly; it can be -20% one year, or even -80%. (In your case, your losses are fortunately limited to 100%.)

Will you be mentally OK if your £thousands shrink even faster than you can invest?
Can you keep your inner self from second-guessing your decisions (or worse, cashing out what you have left) while you're losing money?
Will you still have the discipline to put your monthly £50 in?

That is risk appetite...and that is what "high-risk" investments require of you. The thing is, like courage, people don't know you have it (least of all, you) until you're actually in situations that require it.

Answer 2

They may well be concerned that, if the fund does not perform, they could be in trouble for mis-selling further down the line if you made a complaint. Following the financial crash, and various mis-selling scandals (PPI, packaged accounts, mis-described funds and hedging instruments to name a few), banks are under a lot of regulatory scrutiny and on the whole are being quite cautious as to what business they take on.

You mention you are inexperienced at investing and normally risk-averse. According to the Money Advice Service, one of the criteria for mis-selling is "the product didn’t suit your needs or attitude to risk that you discussed with the adviser", so this could have influenced the decision.

Answer 3

Simulations of people who invested as the worst possible times show that they still end up as millionaires in the long run. What's the trick? They didn't sell.

A well-intentioned financial advisor would be shielding you from what they assume is your own incapacity to handle the high variance in standard investments such as the S&P. If the S&P tanks one year, you might irrationally want to pull your money out before it "gets worse," which is almost surely a losing proposition. Alternatively, if you actually do need to access that money to pay for (insert untimely personal calamity) that you didn't adequately plan for with an emergency fund, you'll have gotten hosed by being forced to realize that short term loss, even if you know that that is exactly what you're not supposed to do. The risk wasn't in the S&P, since we know it blows up from time to time, but was instead in your own inability to make prudent decisions with that knowledge.

Answer 4

My understanding is that low risk investments are a preferred selling point to first time investors because first time investors are generally going to be less into the whole idea of investing, and are probably going to just be 'trying it out' so having less risk means that the person will likely gain money which gives them confidence to invest more and more.

If on the other hand the first time investor loses money on their first investment then they could potentially be discouraged from the whole 'investment thing' and pull out of it.

Answer 5

I would assume that it is because newer investors in general have less of an understanding of what they are doing and what to expect than people who have been in the game longer and who have more assets.

Additionally, higher risk investments typically have a larger dollar cost swing than safer investments do on a day to day basis. If someone has experience dealing with safer investments (say, VFINX) then they are maybe more prepared to handle the greater swings in the riskier side without doing something stupid.

In a general sense, it could be said that panic selling is one of the stupidest things people can ever do when it comes to their investments.

In a general sense, it could also be said that panic selling typically occurs at a greater rate the more that the investment goes down compared to some kind of benchmark. Common benchmarks here are the original purchase price and the highest price the investment ever displayed.

Because of things like this, it's commonly advised that people do not ever put all of their assets into the riskiest possible investments. Most people would say that not more than maybe 20% of one's total capital should be in "risky" things. I am talking about stuff like Bitcoin here. Nobody should be 100% (or even 50%) in Bitcoin, as an example.

Putting too high of a % into the risky side tends to trigger a panic sell, because it often results in too high % swings from the benchmarks. Presumably, in many of these cases if someone had been 95% into something like VFINX and 5% into Bitcoin, then the greater volatility of Bitcoin would have much less negative impact on a benchmark (total account displayed value).

Also, it's important to note that it is not a given that increased risk results in greater risk adjusted rewards over the long term.

Bitcoin is WAY more volatile than an index fund like VFINX, but it is not at all clear that this means Bitcoin will have greater long term rewards. A large percent of the time, the riskier investment just goes bust instead of going up at a greater rate.

Stepping back a bit, there is no investment that has been proven to be placed at a better point on the risk/reward curve than S&P index funds like VFINX which have the lowest achievable fees. What that means is that you could put all your money in that and feel happy knowing there is no historically better "on paper" thing you could be doing.

Even the volatility there is a lot for most people, though, so most people are probably encouraged to take a step back from there for their risk/reward profile. That's where people say you should do age % in bonds or something like that. Steps like these help to stabilize the benchmarks and prevent people from making catastrophic investment errors even further which is a great thing.

The absolute worst thing one can do is to cause a catastrophic unforced error. You want to be maximally far from that at all times no matter who you are.

Answer 6

Direct and to the point of what you are asking: an (ethical) advisor will steer you away from a situation where you have a significant chance of losing money in the long run. I don't know what laws there are in the UK about this but they may also have a fiduciary responsibility to their customers. With that comes a general framework around what kinds of investments are appropriate based on the client's financial situation.

When you are a new investor, this investment is all you have. More experienced investors already have built up wealth. They can afford to add some higher risk to their portfolio. If an experienced investor wanted to move 100% of their assets to a high-risk investment, the advisor would likewise advise against such a move.

Answer 7

One of the first steps in a successful financial advisory relationship is to develop a common understanding. This ensures that when the advisor says something the client understands exactly what they mean and vice versa. Advisors inquire about current/prospective financial information (to the extent knowable) and client ideas on risk and return. The presumption is that current income is in excess of current needs, and periodic consumption vs. savings amounts can be determined with some degree of certainty. Savings vs. investment amounts depend on risks to current income (ability) and investor risk-aversion (willingness). You mention rental income. Does this supplement any earned income? You mention cash savings that does not exist as such, and you describe having sunk it into a property, which connotes a mortgage you reluctantly had to pay off using your savings. If you made the choice to fully own the house, it sounds like more of an investment where you traded the safety of savings and the offsetting mortgage obligation by assuming property market risk with the offsetting rental income. This is neither good/bad in and of itself. You also mention the case of an emergency, which is an important consideration, but which contrasts with your self-described risk-aversion. Cash is definitely good in an emergency, but the emergency implies access to cash might be harder to come by when you need it i.e. banks want to hold cash too, collateral values and rental rates fall, all lessening your ability/willingness to repay any loan or liquidate property.

Speaking generally about how your situation would be looked at in the US, and without much more details and figures, I can only speculate that for $600, without any other banking relationship with this institution, it would not be economical for them to open up an investment account with you. They may simply have higher minimum initial amount requirements. Did they take down your income and discuss your investment objectives. At a minimum someone there should be able to direct you somewhere else.

A few notes of caution when it comes to assessing investment products, particularly of the fund variety. Whether or not a product is suitable for an investor has nothing to do with its short term recent performance. High-risk also doesn't always translate. The quality of the management and the integrity of their process are much more important, and lower expenses charged by funds has tended to be the best predictor of future relative performance (vs. peer group funds).

Individual investors are notorious for chasing fund performance such that the average fund investor has earned significantly lower returns compared to the average fund performance figures. This speaks to your mentality of smaller periodic and systematic investments over 10+ years, which offsets some emotional biases that destroy most investors who buy at the top and sell at the bottom.

In sum, a systematic disciplined approach is your best path to success. That includes minimizing investment expenses and not chasing performance. It is possible that the bank funds are not available to investors not meeting asset/experience criteria, but I can assure you that does not mean that long-term investment success is not available to someone such as yourself. They should have explained that better. In fact, the most proven path toward long term investment success can also be identified before the fact in the form of low-cost index funds. It's difficult to predict who the best manager is going to be in the future. That's why most funds fail or underperform.