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A trade-off between risk and return

Daniel Needham  |  06 Mar 2012Text size  Decrease  Increase  |  
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Daniel Needham is the chief investment officer of Ibbotson Associates.

 

Over the long term, investment strategy is the key driver of investment outcomes for clients and determining the most appropriate investment strategy is about trading off wealth appreciation with capital preservation within the investor's time horizon.

Without trying to oversimplify a highly complex area, the trade-off of risk and return is the most important step in determining the investment strategy specific to each individual. Getting this balance right is critical.

Too much risk can lead to the individual selling when markets are down and capitalising losses. On the other hand, not enough risk can lead aggressive investors to chase expensive assets after they have performed well.

The term "risk" is used a lot in our industry, but is not well-defined and is normally associated with volatility. Like most things in finance there is always more than one perspective and solid arguments for and against.

While volatility of an asset has generally won the day, it doesn't do a great job of predicting losses. Losses are ultimately the thing that investors are worried about. It isn't really possible to generate returns above cash without bearing some possibility of loss, but that risk should only be taken with an expectation of sufficient reward.

Theoretically, there should be a positive relationship between return and risk over the long term. However, this doesn't hold over shorter periods and at times can be inversely related (that is, more risk for less return).

It is important to understand that just because equities have outperformed bonds over the long term doesn't mean it will be the case going forward over shorter time periods. Conversely, taking extra equity exposure doesn't mean you will get higher return - it may mean the opposite.

What matters, ultimately, is valuation, the price of an asset relative to its underlying fundamental value. Returns and losses are conditional on valuation.

What does this mean for an individual's investment strategy? Assuming the investor understands their preference for return versus risk, it means that assets shouldn't automatically be included in the portfolio (other than cash for liquidity). However, it may mean some assets should be excluded or their exposure limited.

A quick example should highlight this point. Take a conservative investor who doesn't want to lose more than 5 per cent in any year and wants the ability to liquidate the portfolio close to the market value some time in the next three years. This investor is going to find it difficult to allocate any capital directly to private equity or real estate as the liquidity constraint alone would exclude these investments.

It also means an allocation to more volatile assets will only have small exposure due to the potential for large fluctuations in prices. Even if they're cheap, the uncertainty of capital markets and the investor's liquidity needs mean they can't have a major role in the portfolio.

Despite the potential upside, periods of high volatility can create capital losses if the trade-off between risk and return is inappropriate.

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