Congratulations to Simon Hudson-Peacock whose article, “Paint risk based masterpieces”, was published in the August 2017 edition of the Financial & Advisory News.
A new client walks into my office. I can see that she is nervous. She has received a windfall and wants my advice on how to invest it. “I want the highest possible return without any risk,” she challengingly declares.
This is always going to be a potentially fraught interaction requiring delicate client education.
The client may not like what she hears, but the truth has to be told… risk and return are joined at the hip and this empirically proven relationship underlies most of modern day financial economic theory.
The trick is to turn this expectation around. In truth, what the client actually wants is the highest possible return at a risk that she can live with.
In this way, the conversation gets turned around. Ask: what is this money going to be used for? When do you envisage needing to access it? How does it sit within the rest of your financial assets?
Risk means different things to different people. For me, risk is synonymous with timing… the riskier an asset, the more time you need to be confident of achieving your expected return.
While recent experience might suggest otherwise, it is widely accepted that over time, equities will deliver higher returns than bonds. Further, both equities and bonds will deliver higher returns than cash. Why? Because the risk of owning each type of asset differs, and the investor needs to be compensated for this risk.
Indeed, it follows that even higher returns should theoretically be possible within the realms of emerging markets, venture capital, private equity and other more alternative markets such as art and antiques.
We create investment strategies for our clients by combining different asset classes; each investment strategy will have its own expected risk and return characteristics.
The most beneficial of these portfolios to our client is obviously the one that delivers the maximum return for the risk that she is willing and able to carry. In investment theory, this is the portfolio on the efficient frontier.
Within the asset class return, assumptions used to construct such portfolios lay a whole host of other risks.
For example;asset specific risks,company risks, industry risks and country risks. Also, global factors such as geo-political crises and emerging market risks.
Investing in a single share from a single stock market may well give you an equity return over time, but such a return is likely to come with significant volatility.
So when portfolio managers talk about the benefits of diversification, they are alluding
to the fact that, by creating a portfolio of independent investments, they can deliver or outperform a desired asset class return with a lower level of volatility.
Timing risk has another, less obvious side to it; the risk of missing market returns altogether. In its 2014 Guide to Retirement, JP Morgan pointed out that missing the 10 best days out of the previous 20 years would have reduced annualized returns from 9.2% to 5.4% due to the enormous compounding effect of those few days’ returns.
Returning to the client So let us return to our client. We have convinced her that she actually has a risk budget rather than no risk tolerance at all. With this risk budget, she should be able to achieve a certain level of return.
Our job is to now to make sure that this occurs as efficiently as possible. We can do this by:
• ensuring the best-expected return for the risk budget through appropriate asset allocation;
• diversifying where we can across manager styles and across markets; and
• staying invested; do not try to time the market.
In this way, we meet our client’s needs by managing their return expectations while delivering on these expectations without taking unnecessary risks.