Reframing risk

By Morningstar |  24-09-20 | 
 

In 14 ways of looking at risk, we offer a framework. Mark LaMonica from Morningstar Australia talks of asset allocation in the context of risk.

When it comes to investing, the most straightforward actions often have the biggest impact on future returns.

Focusing on…

  • Saving more
  • Time in the market
  • Reducing expenses
  • Minimizing taxes

can have outsized influences on where you end up.

Many of these areas typically get overshadowed because investors tend to overly focus on selecting products. Deciding which share or fund to buy is the focus of many investing discussions and take up a disproportionate amount of the time investors spend on their portfolio.

An area on which investors focus too little attention is asset allocation.

Asset allocation is a classic example of a straightforward action that can heavily influence future returns.

Academic studies frequently seek to measure the impact of asset allocation decisions on returns. While intellectually interesting and important to the field of professional money management, these studies largely overlook what matters to individual investors. As individual investors what should matter to us is achieving the goals we initially set when we started.

Asset allocation refers to the mix of different assets in our portfolio. The choice of which assets to include in our portfolio and the percentage allocated to each will have a meaningful impact on our ability to meet our goals. Each asset class—and to a lesser extent the underlying sectors and geographies of the assets—has a distinct risk and return profile.

As investors, we are compensated to take on risk.

That compensation is in the form of the returns that we earn from each investment. It is the return you earn that connects your current portfolio with your goal.

That return comes at a price. That price is the risk you are taking on.

The investment industry measures that risk in terms of volatility, or how much the asset class is going to fluctuate. There are a variety of volatility measures that professional investors talk about. Standard deviation and beta are just two of the more straightforward terms you often hear. These terms confuse many investors. A cynic may say this confusion is designed to reinforce the notion that investing best left to the professionals. A more generous take is that these terms are useful if you are managing large pools of investor money and aren’t focused on the goals of the investors making up that pool.

Volatility is a risk.

It can be devastating if a large decline in value occurs right before you need your investments to pay for your goal. But as a long-term investor you should be less concerned with how much your portfolio is going to bounce around in value and more concerned if your portfolio has been designed to give you a reasonable chance to achieve your goal.

The real risk that you face is failing to achieve your goal. When we think about risk in terms of achieving a goal, we can reframe the narrative.

Thinking about risk as volatility could cause a risk-averse investor to have 100% of their portfolio in fixed deposits, small savings schemes, and bank accounts. That asset allocation decision eliminates all the risk in the portfolio in terms of volatility. Many people believe this is a safe option. In a very narrow sense, this makes sense. It’s reasonable for someone to say they avoid the stock market because they fear they will lose money.

Leaving 100% of your portfolio in cash guarantees that you’ll fall short of your goal if you need any sort of after inflation return on your money.

Many people diligently save but avoid leaping into investing because of the fear of volatility. If you are on our website and reading this article it is unlikely that you figure in this cohort. But you can still be focused on risk and at the same time improve the design of your portfolio. Thinking about risk in relation to the ability to achieve your goals makes it easier to focus on your risk capacity.

Your capacity to take on risk is directly related to your goals and the returns necessary to achieve them.

If the volatility associated with the return you need to achieve your goal is an issue then you can rationally make trade-offs with your goal. Maybe you need less money to retire; perhaps you can delay your planned retirement or save more. All of these levers will lessen the required return needed to achieve your goal.

However, if you think of volatility as a necessary evil to achieve a higher return you might be able to make asset allocation decisions that give you more of an opportunity to achieve your objective.

To get started, do this:

  • Define your goal with a reasonable degree of detail. Estimate how much (post inflation) money you need and when you need it.
  • Take a look at what you have currently in your portfolio and estimate how much you can save.
  • Calculate the required rate of return to achieve your goal given the above inputs.
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