A portfolio for the times
A guiding principle should be that the potential for returns needs to outweigh the likelihood of losses
We’ve all heard the saying – with greater risk comes the potential for greater returns. While this adage holds true for the most part, understanding different kinds of risks and how to mitigate them is more nuanced than taking a pot-luck guess at how much of it you can stomach.
Know what they are SEQUENCE OF RETURNS
Sequencing risk is when investment market volatility meets with the cash flow coming in or out of your investment portfolio (see figure). When there is no volatility, the sequence in which you receive your investment returns won’t matter. Conversely, when there is no cash flow, every dollar of your initial investment experiences every return, be it positive or negative, so again sequence won’t matter.
However, when there are cash flows, the sequence will matter as not every invested dollar will experience the return from every period – new inflows miss the earlier returns and outflows miss any subsequent returns. The sequence of returns is a critical risk for investors nearing the end of their working years or in retirement.
“The path of returns [for retirement] is often overlooked
“Diversification requires ensuring your capital is exposed to economies outside Australia”
due to a focus on asset class averages and portfolio returns,” says Michael Armitage, from the FundlLab consultancy.
“The impact of loss at the beginning of retirement, as principal is also being reduced to fund retirement, conspires to destroy retirement plans. Investors no longer contributing to their savings and drawing down capital as markets fall will quickly reduce the longevity of their assets for retirement.”
EMOTIONAL RISK
Investors claiming to be long-term often betray their own strategy by succumbing to fear of short-term negative events.
Accordingly, staying the course may be one of the easiest risk mitigation strategies around. This requires ignoring the day-to-day market noise.
“Investors typically do not achieve asset class returns due to poor investment decisions,” says Armitage.
“Arguably, portfolios with less volatility and perhaps less headline return will have a higher probability of meeting long-term objectives due to an increased likelihood of investors staying on track and enjoying compounding returns.”
ASYMMETRIC RISK
Benjamin Graham, the father of value investing, once said: “The essence of portfolio management is the management of risks, not returns”.
It follows that an investment should have greater potential to make a return than it does to make a loss.
Based on this logic, long-term investors should look for where the potential for returns outweighs the risk of losses, or what’s known as an asymmetric risk profile.
“This is something that is intuitively well understood but not necessarily expounded upon,” says Kristian Walesby, chief executive at ETF Securities Australia. “When people talk about volatility risk, for instance, they forget that often you have long periods where the risk is positive or the risk is negative.” Walesby points to the example of tech stocks. “Despite being mathematically risky, because they have high propensity for price change, they’re asymmetric over five years because that risk was skewed towards positive returns,” he says.
This positive risk weighting is predicated on both the long-term performance and the intuitive understanding that the technologies these companies are developing are fundamentally changing the world and are here to stay.
Portfolio construction
With an understanding of the different forms of risk, an investor can then start thinking about building a portfolio that best weighs risk with investment outcomes.
Building a portfolio should be an exercise in mitigating risk, not eliminating it altogether.
It starts with the investor setting out what they want to achieve from their investments. That could be a certain lifestyle in retirement or the ability to live in a desired house or suburb.
The next port of call is to construct a portfolio that meets those goals.
Most experts agree that portfolio construction is about the types of assets and their relative proportions being more important than the differences between assets of the same class and nature.
“When the stockmarket or bond market moves, most assets tend to move in a similar direction,” says Damien Klassen, from Nucleus Wealth.
Emanuel Datt, from Datt Capital, says investors should also cap their exposure to any single investment within an asset class.
“This structurally restricts or sets a maximum loss for any given investment in case of failure, and should the asset level risk assessment be flawed, providing a ‘fail-safe’ for the investor.”
Returns can be achieved with a variety of risk profiles. The barbell approach involves holding the majority of assets (90%) in risk-free or cash-like assets with a relatively small percentage (10%) within extremely high growth, ideally asymmetric positions.
“Within these portfolios an absolute worst-case scenario is a known -10% with the ability to have high level of returns,” notes Armitage.
“However, investors within the portfolio holding 100% of medium-risk assets are at risk of ruin if they have measured their level of risk and expected asset class correlations in error.”
Walesby likes to use the analogy of managing a soccer team.
“A team that is comprised of entirely average players will likely only generate average returns. On the other hand, a team with expensive strikers will have more upside potential,” he says.
To expand on this analogy, high-risk strikers can be risk managed by including dependable defenders that minimise the team’s losses.
Investors should view their portfolio as exactly that, an entire portfolio. That is to say, a stock portfolio shouldn’t be viewed in relative isolation to the entire investment portfolio.
Take home ownership, an investment class that has become a rite of passage in Australia.
“Most Australians have a house that, if they’re under 50, they also have a high degree of leverage to,” says Walesby.
“So they are invested ultra-long term in Australian property. They should then, as a matter of course, be considering a range of equities (based on risks) both domestically and overseas and the same for fixed
income – trying to build the portfolio so that property becomes less and less the dominant part.”
Diversification
Diversification is the most well-known risk-mitigation strategy, and you’ll be hard-pressed to find an expert who doesn’t recommend it for everyday investors.
The logic is simple: the more “bets” you have, the less likely you are to suffer deep losses.
But it’s so much more. “Diversification is fundamentally one of the most misunderstood themes in investment, as it cannot be viewed solely in isolation,” says Datt.
“Many investors believe they are diversified because they invested in multiple equities; without necessarily understanding that the correlation of these equity returns is high. In a nutshell, this means that in markets the equities held will have a high probability of rising and falling in sync.”
Datt believes investors should approach diversification as a top-down exercise, investing across asset classes to mitigate the effects of positive correlation, which should theoretically lead to more robust outcomes.
“You need to know what you are diversifying,” says Damien Klassen. “In some cases, it is the risk between different asset classes; in other cases, it is geographical risk, or business model risk, or political risk or economic cycle risk. Diversification needs to be a mix of all of them.”
The Australian approach to diversification demonstrates this lack of understanding.
“Many do-it-yourself investors believe diversification is holding three or four of Australia’s banks, or both of our grocery retailers, or two different miners. This is clearly wrong and misunderstood,” says Drew Meredith, from Wattle Tree Partners.
“True diversification requires allocating across multiple asset classes apart from the popular term deposits and high yielding Australian shares.”
This means investing in assets that behave differently, be it government bonds, corporate bonds, direct property, infrastructure, overseas shares, hard commodities like gold and even multi-asset or hedge funds made popular by the Future Fund but which performed well during the current crisis.
“Diversification requires ensuring your capital is exposed to economies outside of Australia, some that are growing faster or which are better supported by government policy. It also requires investing into sectors and multi-national businesses that simple don’t exist here, like Microsoft, Google or even Walt Disney,” says Meredith.
When balanced isn’t balanced
While many managed funds claim to be ‘balanced’, often they’re anything but.
Superannuation members hold most of their money in diversified investment options. However, while they are classified as growth, balanced, moderate or conservative, there are no hard rules about how super funds label these options.
“Some funds may have an option they call their balanced option but in reality it has heavy weighting to growth assets, so it’s really a growth or maybe even a high-growth option,” says Alex Dunnin, director of research at Rainmaker Information, which publishes Money.
“This ambiguity may seem absurd to many fund members, but it happens because a super fund may invest into property because it delivers a capital growth return as well as a rental income return.
“As a result, how you split it between growth versus defensive income investing can be very subjective.”
The GFC provides an apt case study for why balanced portfolios consisting mostly of risk assets such as shares aren’t balanced at all.
“All asset classes fell during the GFC as the markets were concerned with the entire banking system failing,” says Armitage.
“In systemic periods, only the safest of government bonds, cash and precious metals have historically provided a ‘safe haven’.
“Portfolios that had hoped for various factor-exposure equities, or allocations to infrastructure, credit and property, to provide portfolio diversification benefits were reminded what ‘risk-off’ truly means.”
Fast-forward to the current Covid-19 episode and this exposes similarly flawed investment approaches. In the hope of stimulating the economy, central banks have created zero-interest-rate and negative-interest-rate environments. This has pushed most investors out on the risk spectrum in order to maintain longer-term return objectives.
“We have seen this manifest in the over-reliance on risky assets within ‘balanced’ portfolios,” says Armitage.
This is why investors need to understand risk in relation to their objectives, and build a portfolio that gives them a fighting chance to achieve their financial objectives come rain, hail or shine.
Investors need to understand risk in relation to their financial objectives