When I originally broadcast the podcast episode that forms the basis of this blog and the next, I included an interview I did with someone I really admire. Nick Lincoln has been a financial adviser since 2001 and set up his own practice, Values to Vision Financial Planning in 2008.
He produces the Money Hat-Tip podcast fortnightly and is known for his strong views about how advice has been and should be delivered in the UK. Our mutual friend Andy Hart calls Nick his ‘Work Dad’ which should give you some idea of the respect people hold Nick in, and deservedly so.
In the interview, I got Nick’s view on something called capacity for loss which traditionally is closely linked to attitudes to risk in the financial advice process. The interview was so valuable that I’ve included a transcript of our chat below, so you can get a better understanding of capacity for loss.
PM: You presented at the Humans Under Management event last November, which is a conference for financial advisers primarily, but focusing very much on behaviour. You gave a powerful talk specifically dealing with a topic called ‘capacity for loss’, and your strong views on it. I wonder if you can first of all outline what your understanding is of what capacity for loss is? Maybe from the regulator’s point of view, but also your views on it would be really helpful.
NL: My understanding of what the regulator means by capacity for loss, and this, by the way, is one of the issues, because I don’t think anybody can really define it properly, and nobody thereby can quantify it on a client by client basis.
But I think the regulator is saying, ‘Capacity for loss is how far someone’s investment portfolio would have to fall in value before it had a material effect on that person’s standard of living.’ That’s my understanding of the definition.
PM: That matches my thoughts. It’s about people’s ability to withstand losses – that itself is an issue. What issue do you have with it?
NL: I think it’s the defining issue of our times. There are two reasons why I think capacity for loss is fundamentally flawed. The first reason is that it completely ignores the real risk that nearly all of us face, especially people coming into retirement with a three-decade looming up, which for most of people is the timescale involved.
That real risk is inflation destroying the purchasing power of whatever pots of money these soon-to-be-retirees have built up. It emphasises this notion of loss in the investment market and it completely takes the focus away from the real risk, which is inflation.
That’s the first problem I have with it, and the second reason is that there is no loss. Markets never lose money. If you define loss as a permanent loss of capital, then over the last 150 years, no developed stock market has ever suffered a permanent loss of capital.
Human beings suffer losses, because they sell at the wrong time, but markets don’t cause losses, they just have temporary declines. We’re fixated on this word ‘loss’, but actually, what losses are there? It’s a two-pronged thing, and there are two issues I have with capacity for loss.
PM: That makes sense, and that isn’t just semantics. It might be easy for someone to say, ‘Well, we’re just niggling about vocabulary here’, but it’s obviously correct that a loss is only a loss if you no longer have access, or the ability to regain, money or assets that you formerly had.
Of course, while the money remains invested then you do have the ability to regain a previous high or previous level of your investments, whereas if you convert those investments back into cash and sit weeping over your losses, then you are the source of them.
So, it isn’t just semantics, it’s extremely practical. Now, in your talk you emphasise specifically about those in retirement, and really, you’re right – it is a defining issue. We’re turning on its head the formerly accepted dogma that people needed to take a lower level of risk in retirement. Why hasn’t the regulator really got this yet?
NL: The flip answer is that the regulator is staffed by people who have defined benefit pensions and they don’t have to worry about investment risk, and they don’t understand it. The more serious answer is that I don’t think they understand capital markets.
I also think that all of us, including the regulator, from the moment we’re numerate – we go to school and learn maths, we become adults and read the news – we are taught that risk is in the stock market and that cash is safe.
Every media outlet and every source of information reinforces this message. It’s wrong, but it’s massively counter-cultural to push back against that. The real risk for the majority of people is not being in equities, but it’s really hard to unwind people mentally who for 30 years have accumulated money and been told the stock market is risky and as you approach retirement you need to de-risk and go into cash.
What we need to be saying to people is, ‘By all means, if you’re approaching retirement, go into cash. If you want the purchasing power of your pots of money to be destroyed over the next 30 years and for you to run out of money, flee to cash.’ But it’s such a counter-cultural message for people. We have to be really passionate about hammering this home again and again and again.