Have you ever had a detailed discussion about investment risk – both your perceived tolerance for it, based on your personality – and also as an estimate of how your investment portfolio is positioned from a risk perspective?
If not, here’s a bit of background for you on the topic.
What is investment risk, exactly?
One of the most popular definitions of investment risk, and one which makes a lot of sense, is “the permanent loss of capital”. This relates to investing in a company or a property development (think: Steinhoff or Sharemax) that goes bankrupt and ends up being liquidated.
Fortunately, in a sensible, diversified portfolio with a wide mix of underlying investments as well as limits to allocations to single companies, it is very unusual for an investor to have to worry about this extreme form of investment risk materially affecting their portfolio value.
So, what is the more common application of risk measurement?
When absolute, permanent loss of capital becomes less of a focus, measuring risk usually focuses on the volatility of investment returns over different periods of time.
Before considering volatility in more detail, it’s worth noting that there are also other important measures of risk, namely:
- inflation risk: the risk that your funds, especially on an after-tax basis, lag behind inflation over time.
- liquidity risk: the risk that an urgent short-term cash requirement may require the sale of a valuable long-term asset at a less-than-optimal time in the markets.
For the purposes of this discussion, however, let’s focus on volatility risk.
Measuring share price volatility (and why it may be helpful).
One of the regular measures of volatility (i.e., the degree by which the price of a share fluctuates) is standard deviation. Standard deviation is a statistical concept that may be helpful to understand how widely the price of an asset fluctuates, especially if you need to redeem that investment for cash at some stage. Ideally you want to avoid selling an investment when the price is low and near the bottom of a temporary market sell-off.
However, a weakness of standard deviation as a measure of risk is that it includes both upside and downside movements. As none of us is too concerned about substantial swings to the upside, it is fortunate that there’s another approach to risk measurement, namely “maximum drawdown”.
Using maximum drawdown instead.
“Maximum drawdown” measures the largest historical downturn of an investment fund over any time period. The time period from top to bottom is typically relatively short, being a few weeks or months, but for some funds it can relate to investment performance over a couple of years.
Like many measures of risk, there is an inherent weakness in maximum drawdown because the measurement is based on historical data. History does not always repeat itself, and in addition, some funds have longer track records than others, which can make fair comparisons difficult. This is particularly the case if severe periods of general under-performance such as the Global Financial Crisis in 2007/8 are part of a data set of a fund, or if the management style or personnel of an investment fund have changed substantially over time.
However, in the absence of a better tool, maximum drawdown is intuitively sensible and in common use.
Constructing your portfolio wisely matters.
To be constructed wisely, your investment portfolio typically consists of a number of varied investment funds that perform differently over different investment market cycles. It is a complicated calculation to factor in performance correlations between different funds and assets.
There are specific strategies that can mitigate against investment risk and market downturns for your portfolio. For example, a typical portfolio should consist of a suitable blend of investment funds (according to your individual, long-term investment planning goals), and as a savvy investor you should ideally have access to some stand-alone cash, so that withdrawals can still be made during turbulent times, while avoiding selling assets at the bottom of the market or paying capital gains tax unnecessarily.
Should you try to avoid risk entirely?
Balancing risk and return are an inherent part of constructing an investment portfolio. If you aim to avoid investment risk entirely, you can end up “investing yourself poor” i.e., finding that the return on your investments lags behind inflation, especially after tax has been taken into account.
In short, investment risk (of the temporary-fluctuation-in-value type) is the price we all pay as investors to achieve superior longer-term returns. Not all investors can sleep at night knowing there are short-term fluctuations in the value of their wealth – but data shows that if you can, you are likely to be well rewarded over the long-term!
What’s your current risk profile?
Speak to your CERTIFIED FINANCIAL PLANNER® Professional at your next annual review about the current level of risk vs. reward in your investment portfolio, and whether it is still appropriate in terms of your long-term investment goals.
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Richard Sparg, CFP® CA(SA)
Wealth Manager
