The Art and Science of Risk in Investment

A deep understanding of risk and its management is key to creating a portfolio that yields maximum returns

Some people have an appetite for risk. Plenty of thrill seekers jump on to off-road motorbikes and ATVs, or hurtle down black diamond runs on a snowboard, and reap the adrenaline-based rewards.

With the meteoric rise of online trading apps, we are now seeing many amateur investors flying down metaphorical black diamond runs to ride the stock markets aggressively.

I have done both in my younger days; snowboarding was a true passion of mine, and so was speculative trading. While I still love snowboarding and hope to get back on some of the more challenging slopes again in the future, I have built a very different view when it comes to speculative trading.

It is broadly understood that investing comes with risks. I believe that a deeper understanding of what these ‘risks’ mean to you and how to manage them, instead of making decisions on impulse, is key to creating a portfolio that provides maximum returns by taking on the optimal amount of risk.

The dimensions of investment risk

Past returns have almost no correlation with future returns. A study by SPIVA measured the top performing funds in 2017 and a year later, less than 47 per cent maintained their top-quartile performance. By September 2019, less than 3 per cent of all equity funds kept their top-quartile status.

However, one thing an investor can properly manage is risk.

There are three fundamental ways of assessing risk when we start a new investment process with an investor: risk needed, risk capacity, and risk tolerance.

How much risk is necessary?

Firstly, the risk needed is the amount of risk necessary to achieve certain financial goals.

For example, we have two investors: Investor A, who is willing to invest $500,000, and Investor B, who will invest $800,000 – both want to grow their portfolio to $1 million in the same amount of time. Investor A will need to generate profits of 100 per cent, while Investor B only needs to grow his initial investment by 25 per cent. Therefore, given the same time, the level of risk needed for Investor A to reach his financial goals would be much higher, in order to get higher potential gains.

How much risk can you tolerate?

Risk capacity is based on an investor’s lifestage and lifestyle, and essentially measures how much risk they can afford to take on based on their circumstances. Metrics such as age, income, marital/family status, and desired investment goals, can all give an indication as to how much risk someone can potentially take on; an unmarried professional in his late 20s can likely bear more risk than someone in his 50s with a mortgage, children and retirement plans.

However, all of this is situational – it doesn’t take into account an individual’s willingness to make risky bets, or to react irrationally when the market wavers.

Risk tolerance is where things get really personal, and is ultimately based on an investor’s comfort level when taking risks. It is a measure of personal behavioural traits and gauges the emotional response to risk.

Loss threshold

It is important to note that investments can go through periods of temporary drawdowns (losses). Understanding your loss threshold while choosing your investments is key to remaining invested and not panicking when the markets are volatile.

For example, a loss of 10 per cent necessitates an 11 per cent gain to recover. Increase that loss to 25 per cent and it takes a 33 per cent gain to get back to break even. A 50 per cent loss requires a 100 per cent gain to recover and an 80 per cent loss necessitates 500 per cent in gains to get back to where the investment value started.

When an investor does not take on an appropriate level of risk, it makes it more challenging to stick to his investment plans, making him more susceptible to making emotional decisions, and “realising” a loss which previously might have only existed on paper.

Building ‘risk guardrails’ with diversification

Regardless of your risk profile – even if you are someone who is able and willing to tolerate relatively high risk – you should build your overall investment portfolio in such a way that it provides protections against major losses.

The most important guardrail is diversification, which is the process of investing in assets that aren’t closely connected to one another. This has been said many times on repeat, but there is a good reason why diversification is said to be the only free lunch in the world.

One way is asset diversification where you allocate an optimal mix of different types of asset classes in your portfolio. Investing in different asset classes, such as equities and bonds, is a basic first step here, but ultimately, a well-diversified portfolio is one that has a meaningful allocation to multiple asset classes, sectors and geographies. The most common assets considered in portfolio allocation are equities, which are more volatile, but may offer higher long-term returns, and fixed income investments, such as government bonds, with guaranteed returns but slower, steadier growth.

Typically, we divide asset allocation into three broad groups:

  • Defensive portfolio: 70 per cent to 100 per cent in bonds.
  • Balanced portfolio: 40 per cent to 60 per cent in stocks.
  • Growth portfolio: 70 per cent to 100 per cent in stocks.

For long-term investors looking to invest for their retirement, a growth portfolio is generally recommended given its ability to take on higher potential returns by allowing time to wash out the volatility. Beyond stocks and bonds, you can also consider adding real estate or commodities to your portfolio. Also, for those who believe in the future of digital assets, a small allocation (1 per cent to 5 per cent) to crypto assets (which are probably the most volatile) can be considered too.

Another way to further spread out your risk within each asset class is company and sector diversification. As an example, the equity portion of your portfolio shouldn’t just consist the shares of one or two companies. One way to do this instantly is to use exchange-traded funds (ETFs) to build your portfolio. Think of ETFs as a bucket that holds a collection of stocks, bonds, or commodities, across a broad range of assets built to mimic a market index. Most ETFs are passively managed investments and thus likely have lower fees than mutual funds. They are also cost efficient and liquid because they can be traded like stocks.

Lastly, a commonly used strategy that can assist you in spreading out your risks over time is dollar cost averaging (DCA). If you have received a cash windfall and want to invest it, studies show that lump sum investing can help you reap better returns.

However, for those who don’t have a large amount of starting capital, DCA is a good strategy to invest consistently regardless of market conditions and put your money to work as soon as possible. It also removes a lot of the emotion from investing, and can help to create discipline during more turbulent economic periods.

A balanced approach is key

How do we put all these to work in our portfolio? One way to adopt a balanced investment approach is by adopting a core-satellite investment strategy. Commonly found in many institutional portfolios, this strategy has caught on among retail investors.

One way to visualise this strategy would be to think of a planet surrounded by its moons – a core of long-term index investments is surrounded by complementary satellite investments which offer the potential of enhanced diversification, outperformance, or both.

It’s often said that happiness in life is about achieving balance, and so too with investing. Our goals may differ from person to person, but by knowing oneself across the different risk dimensions, and building good risk guardrails while investing, one can more confidently stick to one’s investment plans without being swayed by market movements. And for me, it is simple knowing that my money is working hard at a level I’m comfortable with, and not worrying about the outcome when I am sleeping.

The writer is founder and CEO at Syfe. This byline was first published on The Business Times.