Smart Investor portfolio report: risk profile

Smart Investor – portfolio supplement, August 2011

Before you can make a single investment decision, you need to know yourself. You need to know what you want from your investments, and in particular you need to know how comfortable you are with risk. Without knowing this, you can’t begin to implement an investment portfolio that is appropriate, because you can’t know what ‘appropriate’ is.

What is risk, really? Different people define it in different ways.

“To us, it has two characteristics,” says Paul Moran of Paul Moran Financial Planning. “The first is the technical view: that risk is the volatility of returns – in other words, the uncertainty of what next year’s return is going to be. The less certainty, the higher the risk.”

The second, he says, is less technical and a lot more sinister. “An investment that has a possibility of absolute loss.”

Darren Johns at Align Financial leans more towards the second of Moran’s definitions than the first. “The finance industry talks about risk, and what they tend to mean is standard deviation: variation in returns of investments,” he says. “But most investors, when we ask them what does risk mean to them, what they really mean is permanent loss of capital.” Early discussions with new clients will always try to establish a clear view of what risk is. “Standard deviation, outperformance of beta and alpha – that’s fine for the fund managers and brokers. But for Mr and Mrs Jones, if they’re looking at investment A and investment B, they’re more interested in which one is likely to implode and never exist again.”

Having made that clear, Johns then talks about three dimensions of risk. One is risk appetite: how much risk people are comfortable taking on. “The industry tends to talk percent on the way down and dollars on the way up,” notes Johns. “They say: you’re down 24%. But: you made $200,000. 24% sounds like you might get it back in a year or two. But when you think of it in dollar terms, is that something you’re comfortable with?”

The second dimension is risk required. “Not everyone has enough capital to put it in the bank and get 5% and not require risk,” he says. “Some people require some risk to get to 7, 8, 9%.”

And the third is risk capacity: the extent to which people’s investment plans, or lifelong financial ambitions, can continue in the event of poor market conditions.

“They’re three different conversations,” he adds. “Risk required is easy, because it’s numerical. If you’ve got a million and you want to spend $80,000 per year, the conversation is quite straightforward.” Risk appetite is more challenging to pin down. “That’s hard, because until you’ve lost money, it’s hard to say how comfortable you will be with it.”

People tend to bring misconceptions about the risk of particular asset classes. “Typically a fixed income investment is considered to be low risk,” says Moran. “If I invest in a mortgage, in theory I’m certain to get a particular interest rate in the next 12 months. Well, that’s fine provided the person pays an interest payment, but in fact there is a risk of absolute loss.”Additionally, people tend to put all of an asset class into the same risk band, when in fact they all cover a multitude of levels of risk. “People think all shares are the same, and that all fixed interest is the same,” Moran says. “So they will equate, for example, investing in Westpac bank shares, with investing in some small speculative mining company. And that sometimes leads them to a decision like ‘I don’t like investing in shares, or I do like investing in shares’, when instead you should be asking what type of shares you are talking about.” The same is true of fixed interest: there is a world of difference between a cash account and a high yield or structured bond fund, for example.

Once his clients have understood risk, the next steps are easier. “Once we’ve clear about that concept, I ask the question on an individual investment basis: is the risk I’m taking worth the return I expect to get?”

When it comes to asset allocation, Johns’s approach is to “draw three buckets. If you strip it back, there are three things in the world you can invest in: cash, property and shares.” He sees cash and bonds as part of the same group.

Typically he uses this cash/bond bucket to keep things simple. “We use cash and bonds to dampen volatility and provide liquidity,” he says. He doesn’t normally direct people towards more high yielding areas of debt. “If you wanted to take some risk and put it in a heavily geared mortgage fund, or high yield bonds, the upside is capped to maybe 8 or 9 or 10%, but the downside is unlimited. I tell clients to spend their risk budget on shares, where the upside is unlimited. That logic of potential upside – the idea that you could, potentially, be buying the next Microsoft – makes Johns far more inclined to put clients into shares than risky bonds. “On the bonds and cash side, we won’t take risk there; we use it to be safe and secure. We don’t go near high yielding stuff because there’s a long queue if a fund fails or blows up, and I don’t want to queue for money for an extra 1 or 2%.”

While people tend to see shares as high risk – some, notably Alan Jones, regularly use the line that it is no different from gambling – Johns prefers to present share ownership in a different light. “What you’re doing is owning a tiny bit of lots of businesses. We say: you’re going to have a beautifully diversified portfolio of the biggest and best companies in the world, and you’re going to own a little bit of lots of them.”

Moran encourages people to study the risk and return characteristics of each potential investment. This includes the volatility along the way, a key part of risk. “If, for example, I’m expecting 10% per annum from the broad share market, but the range of returns that I’m going to get from year to year might be between plus 30 and minus 20, people might be frightened off by that. So it gets balanced by introducing lower risk assets to that higher risk asset, and the proportion that I put in each of these will determine what my actual risk is going to be.” But he counsels against being too simplistic in portfolio construction. “A common misunderstanding is that if I look at the risk/return characteristics of two investments and put them together, then I should get 50-50, somewhere in the model. But the risk and return of any portfolio will have its own standard deviation and expected return, because different investments do different things at different times.”

On this point, any financial planner will be quick to tell you how important diversification is. “Diversifying assets acts to smooth the overall return of the portfolio, and a smoother return means technically lower risk,” Moran says. Some believe that the more asset classes you can put together in one portfolio, the better, and indeed every asset class can be subdivided into numerous constituents. Shares, for example, can be large or small, domestic or international, and can cover a host of sectors. There are short and long term bonds, there is listed and unlisted property (and within listed property, there is office, residential and retail, among others); there are commodities, currencies, hedge funds. “Diversification only works if I’ve got assets that behave differently at the same time,” says Moran. “If I think I’ve got a diversified portfolio by having four banks in my portfolio, it’s likely they will move as a group. I have no diversification benefit.”

Planners vary on their views on the merits of alternative assets. They like the diversification benefits but tend to be alarmed by anything too opaque. “They can play a role provided I can understand what the risk and return characteristics are,” Moran says. “It’s a challenge with private equity, where the whole point is there is very little reporting of what they are actually invest in.”

Investors today factor liquidity into their risk profile much more than they used to, following some harsh lessons learned during the financial crisis. “A lot of investments that were notionally liquid when they went in became illiquid during the GFC, and some still are,” Moran says. This has changed the way we look at some asset classes. “Pre-GFC, mortgage funds were liquid investments; now they are not. People are now looking at what can go wrong. The people who got really badly hurt in the GFC were the ones who ignored diversification and put large amounts of money into investments that had the potential to become illiquid, and at worst, the potential for very significant capital losses.”

This sometimes seemed to move in ways counter to what most people expect from investments. People lost money through shares, but they remained liquid, and in all but a few cases have bounced back. “Someone who was too risk averse to invest in shares and instead invested it in a higher risk fixed interest investment, like MFS or Basis Capital, didn’t understand that despite the fact it was called a fixed interest investment it was taking significantly higher risks.”

Many Australians consider borrowing to invest, or gearing. Many capital protected products exist around gearing, giving people the impression that they carry no risk, but it’s important to remember that they come with heavy rates of interest too. “The 25-year return in the share market is about 8.5, and the cost of borrowing through a margin loan is about 9.5%, or in an equity loan 7.5 to 8%,” says Moran. “So in a margin loan, I’m expecting that the return from shares will be higher than the long term average.” If that’s not your expectation, then it won’t make sense (although there is a tax consideration too). “The broad principle is that gearing increases your risk, and it only has the potential to increase your returns.”

BREAKOUT: Some questions to ask yourself about risk.

1. Do you know how much money you want to have for retirement, and what amount you want per year to live on?
2. If you’re clear on that, what sort of return do you need to earn in order to get it? Working out the return you need is central to assessing the risk you should expect to take in order to get it.
3. Take a look at all of your current and planned investments. Do you understand how far these can, theoretically, decline and in what circumstances that might happen? Are you comfortable with that?
4. Is your portfolio diversified – and properly diversified, with assets that behave in different ways at different times? If not, you might want to change our asset mix.
5. And within your diversified portfolio, do you understand the different risk profiles of the assets within it – such as small cap versus large cap shares, or normal bonds versus high yield?