"A ship in safe harbor is safe-but that is not what ships are for" - John A. Shedd
The concept of risk in investing is the risk of loss of capital; or is it?
The famous US value investor Warren Buffett said, "Risk comes from not knowing what you're doing."
So, let's explore what are the risk considerations for investment portfolios.
A portfolio that provides the greatest expected return for a given level of risk, or equivalently, the lowest risk for a given expected return is also called an optimal portfolio. The optimal portfolio is based on the concept of risk versus return investing - also known as the efficient frontier model. The efficient frontier was first defined by Harry Markowitz in his groundbreaking (1952) paper that launched modern portfolio theory. The efficient frontier is the combination of corresponding portfolios, for each level of risk, whose composition maximizes expected returns.
There are three broad areas that fall into the category of portfolio risk management; clear financial goals as they relate to your investments, definition of your personal risk profile and knowledge of the risk associated with various asset classes (i.e. cash, stocks, bonds etc.)
Successful management of your portfolio's risk is related to how closely your investment selection and diversification reflect your financial goals. Financial goals include children's education, retirement income requirements, buying a home, wealth building for the next generation, etc.
It is important to understand how a portfolio's risk profile is impacted by financial goals. For example, time is a risk related consideration. If a financial objective is portfolio retirement income and a working individual expects to retire in 15 years time, he/she will intrinsically have the ability to take more risk and seek higher returns than someone who is retiring within 24 months. The need to preserve principal, and take less risk, will increase as the retirement date approaches. However, an individual's investment portfolio, and its ability to provide for projected retirement income needs, may require a greater risk orientation to achieve this goal if it is clear that it will not otherwise accomplish its goal. On the other hand, the portfolio may be sufficiently large already so that it may be constructed with a lower risk orientation geared for a lower rate of return target.
Another example is the purchase of a primary residence. When a family is buying a home, usually it will be determined that a certain sum of money will be reserved for this purchase and the decision normally occurs 12-18 months prior to the actual investment. This short-term time horizon dramatically increases the risks associated with investing in stocks and longer term bonds. The wise decision is to keep these funds, earmarked for this specific purpose, in low risk investments until they are need for buying the home. Monies that are not geared for losses, should not be put at risk! This may seem obvious but, especially in a euphoric equity market environment, investors are afraid of missing out on upside opportunities while discounting the risk of sudden declines in the markets.
Defining your personal risk profile is predicated by the importance that you attach to various risk characteristics. Risk of principal, realizing a loss on your investment. This may be caused due to external factors that cannot be controlled or lack of appetite to absorb a decline in the value of investment, even though the decline in value may recover within a short period of time. The issue of a portfolio's value experiencing varying degrees of fluctuation is known as volatility risk. It is important to understand what percent decline in value one is willing to tolerate over a given period of time before feeling compelled to liquidate at a loss.
"One does not discover new lands without consenting to lose sight of the shore for a very long time" - Andre Gine.
Because of cyclical market fluctuations (volatility), time horizon risk needs to be considered. Trying to avoid negative performance in equities by taking extreme short-term positions can actually result in severe underperformance. For example, one survey showed that missing the 10 best days of the FTSE 100 (1986-2004) reduced annualized returns by approximately 33%. Even more interesting, missing the 40 best days over this nine-year period reduced annualized returns by 83%! Statistics show that the longer the time horizon, the higher the probability of achieving superior returns from risk-oriented investments versus risk-free alternatives. For example, the case is extremely compelling when comparing returns from equities to money market funds or bank CDs. Market timing, the ability to enter at a market low point and sell at a market high, has not been demonstrated to be an effective strategy for investing. In every new market cycle, there will be "gurus" who call the market right.
But no expert has shown the ability to consistently identify market highs and lows. Foreign currency risk should be taken into account and currency diversification should be applied to reduce single currency exposure. Erosion of buying power is a risk more associated with the impact of inflation on what we can buy with our money. This issue tends to be of greater relevance for retirees who depend on their investment portfolios to supplement income that they are receiving from other retirement plans (i.e. insurance programs, annuities, pension funds, provident funds/IRAs etc.).
Typically, risk-free investments will not enable a portfolio to grow at a rate that will outpace inflation and preserve buying power. Interest rate fluctuation and credit risk are issues that need to be considered, especially in the construction of a bond portfolio. Adequate investment diversification reduces the sensitivity of the portfolio's bonds to interest rate or credit rating changes. Opportunity loss may be a less obvious risk, but it is no less important to understand that the less risk exposure normally means the less opportunity for superior returns. And, of course, the final risk consideration is emotional risk. It is important that one's investment portfolio's risk orientation does not interfere with sleeping well at night. On an objective plane, some individuals' portfolios could have a greater risk orientation but the personal comfort level will outweigh other considerations. If there is not a necessity to strive for higher returns, and therefore take higher risk, then personal comfort level should become the major consideration in determining the portfolio risk profile.
Asset classes have their own risk characteristics attributed to their volatility and liquidity (the ease to sell at any moment in time). Asset class risk is normally defined as ranging from aggressive/speculative to low risk. Investments which range from high to low risk include commodities, precious metals and futures, to equities & bonds of various levels of risk to money market instruments and cash.
Most investors demonstrate a home bias in investing. This prejudice towards investing almost exclusively in one's home country's stock and bond markets comes at the expense of lost opportunities to exposure in superior performing markets and greater downside risk through the portfolio's almost total concentration to one geographic area. European, American and British households, for example, invest only 15-25% outside their borders. The Dutch are an example of the other end of the spectrum, investing up to 80% outside their country's markets. Global asset allocation and diversification across the entire range of asset classes and geographic regions has proven to be the most effective means to obtain the maximum return for a given level of risk In the final analysis, the measure of success of your portfolio's performance is based on the correlation to its risk level.
The author is the Global Investment Strategist at Tandem Capital