Fundamentals of Investment Risk
Over 94% of a portfolio’s return can be explained by exposure to asset allocation and the exposure to market, small company and distressed stock risk. Despite this fact, this evidence is not made available to individual investors to help them understand markets. Unfortunately, there is a potential conflict of interest in the way that advice is given and investments are marketed. As long as there is a dollar to be made in marketing the golden goose of high returns with low risk, the focus and expense will continue to be poured into the relatively minor factors of stock picking and market timing that feeds the broking fraternity. Despite the fact that these only account for less than 6 percent of the total return achieved in a diversified portfolio, scorn will be poured on anyone who should dare to possibly say it should be otherwise.
Risk and reward are related. The only way to achieve above average returns in an efficient market is to assume greater risk. Risk is far from a simple concept and although there have been a number of ways devised to measure it there are still elements of risk in every portfolio that are not readily apparent. The way to enhance the return on an investment portfolio necessitates taking greater risk or by holding a larger proportion of a portfolio in asset classes that exhibit greater volatility. Volatility is a measurement of risk. Looked at another way, more volatility means a less predictable return, especially over shorter time periods. There are other types of risks inherent in portfolios and these ultimately are reflected in the range of returns achieved. All investments, including cash, bonds, property and shares will achieve the same rate of return adjusted for risk. It is the adjustment for the level of risk that enables the higher return. The higher the return achieved is reflective of the higher risk that is undertaken in that particular portfolio.
If an investor has a benchmark or requirement that their worst case scenario should be the cash rate of return then they must accept this as their best case scenario as well. In order to get a better return than cash they must take a greater risk than that inherent in a cash investment. This is hard for first time investors to understand as during their first market downturn they inevitably say, “I would have been better off leaving my money in the bank over this last twelve months.” This is true; in a riskier portfolio there will always be periods where the performance is worse than cash. It is only in persevering over time that it can be discovered that there will also be times where the performance of a riskier portfolio can be better than the cash rate of return.
“Risks which are inseparable from the opportunities for profit that they offer and both of these must be allowed for in the investor’s calculations…… In most periods the investor must recognize the existence of a speculative factor in his common stock holdings. It is his task to keep this component within minor limits, and to be prepared financially and psychologically for adverse results that may be of short or long duration.”[1]
Markets do not reward investors for taking risks that can be avoided (“diversifiable risk”) but only for investing in more volatile asset classes. There needs to be an understanding that risk drives return rather than being something that can be done away with altogether.
“Investors are exposed to three kinds of investment risk. One kind of risk simply cannot be avoided, but investors are rewarded for taking it. Two other kinds of risk can be avoided or even eliminated, and investors are not rewarded for accepting these unnecessary and avoidable kinds of risk.”[2]
The risk that cannot be avoided is market risk (systematic risk) and is inherent in all markets including property or bond markets. Using leverage or gearing can increase this risk. Keeping a larger proportion of the portfolio in cash can decrease it but it is always there and must be managed. The risks that can be avoided or eliminated are individual stock risk (specific risk) inherent with each company or property purchased and the risk of a particular group or sector (extra market risk) which relates to a particular industry. An example of this is being over exposed to the banking sector. When investors as a group become more confident they tend to unrealistically project earnings far into the future for a favored sector as was the case with the tech boom of the late 1990’s.
So how do these concepts feed into the portfolio construction process? For the average investor, acknowledging the existence of efficient markets can save a lot of wasted time and energy trying to pick the next big thing. It is important to make the distinction between publicly traded markets like the sharemarkets where there are thousands of pieces of publicly available information with buyers and sellers around the world and the residential property market. With housing there are fewer buyers and sellers for an individual asset and hence a greater chance for mis-pricing. Greater numbers of participants make markets more efficient and the likelihood of systematically profiting from anomalies more remote. For one individual to benefit he must not only compete with thousands of others but be better informed than the combined information of all others as that information is priced into the securities.
Far too many people seem to believe they have a unique insight, or worse, are easily persuaded by gossip and hype. These same people have blind faith that an adviser or broker, by dent of their position must know something others in the marketplace have missed. They forget that securities prices are impacted by news and events that are yet to unfold and that current prices are the collective estimates of all participants. A convincing sales spiel or a logical sounding rationale easily persuades these people to take up an offer. They have lost the distinction between investment and speculation. Understanding the simple premise that risk and return are related is an easy way of avoiding financial disasters, such as the “tech wreck” meltdown that occurred in 2000/2002 or more recent crypto currency fiascoes. There is no such thing as a free lunch. It is in ensuring that you only take on broad risk for which you will be rewarded that you begin to apply in a practical sense the lessons of academia. Portfolio construction is about how you determine to spend your risk budget and how you can most efficiently achieve that.
The final factor in this approach reflects the fact that a properly diversified portfolio can minimize many of the risks of investing. Whilst individual assets can have inherent risks, it is in combination that the sum total of risk can be reduced. Counter intuitively, return can also be enhanced by diversification. As a result of Harry Marowitz’s work on the importance of the interrelationships between securities within a portfolio, focus has shifted toward finding asset classes that are distinctly different from each other so that their inclusion can both reduce volatility and enhance return. This is in stark contrast to the seductive appeal and hope offered by market timing and security selection. We all want to enjoy the pleasure of the out-performing sector and avoid the pain of a badly performing sector of the market. In hindsight it seems so simple. As a result of this and the plethora of fund managers willing to assure us of the benefit of their superior skills it is easy to be distracted. The hypothesis that many professional fund managers and brokers can add value through successful market timing and security selection has never been challenged in the minds of many.[3]
The risk adjusted diversified portfolio is achieved by having clear objectives, realistic expectations about returns and an investment time frame in mind before you start. It also entails having an understanding of the factors that impact on investment markets. These factors contribute to the uncertainty of outcome for each asset or asset class. When the portfolio is viewed as a whole there is less of a propensity to panic when one area has a period of under performance or become irrational when one sector dramatically rises. It is the rebalancing back to predetermined proportions that protects the overall portfolio from being inappropriately exposed to one or more risk factors. This is difficult to do as it goes against our natural inclination to sell out of something that has not performed well and to add to something that has achieved superior results. Rebalancing demands we do the opposite, despite that we feel like we are taking from the best parts of the portfolio to put good money after bad by adding to the under performing sectors.
Without this discipline we could never take profits when we are able and we would never add to those parts of the portfolio when buying opportunities are most compelling. Sometimes the benefits are not immediately obvious, as there seems to be very good reasons why a particular sector is languishing and these reasons are usually featured in the popular press. The long term, overwhelming evidence of the success of asset class investing gives us faith to do what we have to do to succeed often in the face of the perceived wisdom of the day.
A considered analysis of these and many other related aspects is an essential element in the process of building a successful investment portfolio. It is critical to understand the interrelationship of risk and return, the implications of globalization on investment markets and the correlation between the various asset classes available for investment. However, this is only the tip of the iceberg. The way to avoid sinking the value of your investments, is to appreciate that there is often much more beneath the surface. Don’t focus on what first meets the eye but rather, pay attention to the broader issues of portfolio construction and risk management. It is so easy to be distracted by our emotions when it comes to money. A sound knowledge of the principles of portfolio construction and the commitment to adhere to those principles no matter what, is your best protection against the temptations of fear and greed when they come courting.
[1] Graham. Benjamin, 1973. “The Intelligent Investor” Fourth Revised Edition, Harper Business 1973 p3
[2] Ellis, Charles D. “Winning the Losers Game: Timeless Strategies for Successful Investing,”Fourth Edition, McGraw Hill, p68
[3] Gibson, Roger C. 2000, “Asset Allocation: Balancing Financial Risk,” Third Edition, McGraw Hill, p14