Equities have been on a tear since the market bottomed in March 2009 during the dark days of the global financial crisis. With market conditions now so bright, investors might be tempted to chase returns. But the bull market is starting to get long in the tooth, and investors should be focusing just as much on risk as return.
Indeed, it’s a good time to be acknowledging one of the great truths of investing: that you usually don’t get high returns without high risk.
The good news is that if investors can understand that interplay of risk and return they will become better, even more profitable investors. Not only will they play the current conditions correctly, but they can select the investments (and Vues) that deliver the right returns at the right levels of risk for them.
Types of risk associated with shares and other investments
If most investors are honest, when they buy shares they’re usually focused on returns, specifically return on capital. That’s the capital gains (share price rise) and income (dividends) you receive from a stock or fund.
But risk is just as inherent to any investment. AAA-rated government bonds are deemed ‘risk free’. But shares and other investments are subject to a number of risks, including:
- General market risk
- Country risk
- Industry risk
- Currency risks
- Geo-political risks
- Liquidity risks
- Company-specific risks
When it comes to shares, risk varies across factors such as:
- Size (small companies are generally more risky than big)
- Sectors (some sectors such as technology are more risky than stable industries)
- Geographies (Emerging markets are usually more risky than developed
No risk, no return
While many disagree, a good proxy for those risks is volatility (or standard deviation of returns). Volatility is basically how much the price of a stock moves around.
Unfortunately, as you can see in the chart above, investments that have a lot of risk generally have a high return (there are no guarantees of course and sometimes this relationship breaks down in the short term).
Emerging market stocks, for example, are much riskier than large cap stocks, so they have a higher expected return (around 7 per cent), but higher expected annualised volatility (well above 20 per cent). Large cap stocks return expectations are just under 6 per cent, but volatility is lower at around 14 per cent.
In simpler terms, the relationship looks like the chart below.
The relationship has been borne out in market performance. In the long term, riskier and more volatile equities have outperformed less risky bonds and cash.
So if you want to shoot for big gains, you have to accept stomach-churning volatility.
There are a number of implications of this relationship.
There is no free lunch
Firstly, there is no free lunch. If you’re contemplating an investment that is likely to give you high returns, you need to be prepared for volatility. You need to realise the road could be a bit bumpy along the way. You need to be mentally prepared to accept that in a high risk, high return profile.
Understand the risk of the investment
The second implication is that when you’re assessing investments or shares you need to understand their risk. If you understand the risk, know the risk and then take the risk, you will be in a much better position than if you’re ignorant of the dangers.
Disciplined investment process
Thirdly, a good, sound, disciplined investment process is important. It will help you ride that volatility. You need to follow your investment process, whatever that might be, and not deviate from it or get emotional during market moves.
We now have real-time market news which creates a lot of noise. It’s tempting to react to developments in a knee-jerk fashion. You don’t need to react to every event or news. Yes, understand them and analyse them, but stay the course.
The final implication, and perhaps most important, is that you have the ability to use the risk-and-return relationship to construct the best portfolio that meets your needs.
That means stepping back and understanding your investment goals. What are you trying to achieve? What returns do you need to achieve those? And what is your personal risk tolerance? You then choose the investments that align best.
You might, for example, be a young person. You want to shoot for higher returns to maximise your chance of an affluent retirement. You are prepared to take on risk/volatility, and because you’re young, your portfolio has time to recover from any volatility. So you might invest in more risky stocks, such as technology, emerging markets and small-caps.
Selecting share portfolios (Vues)
Understanding the risk-and-return relationship also helps you select the best share portfolio (Vue) for you. Our Vues sit right across the risk-and-return spectrum and offer something for everyone, no matter what their return goals are, or their tolerance for volatility.
But some Vues are more conservative and likely to generate solid returns over the long term. High Quality Vue, for example, holds large, stable blue-chip companies such as McDonalds, Pfizer and Daimler; and our International High Dividend Vue focuses on income and sits at the lower end of the risk spectrum.
We’re giving investors different options, so they can pick and choose based on their portfolio and create a well-diversified portfolio that fits their investment goals.
A smorgasbord of options
Share market investors have been rewarded with strong returns in recent years. But valuations are still reasonable relative to earnings growth. And we’re facing a possible paradigm shift with the end of quantitative easing and record low interest rates, and a possible return of inflation.
Investors typically have focused on returns and ignored the other side of the investment equation: risk. But with risks elevated, now is a good time to take a good hard look at risk and its relation to return.
While you might discover there is no free lunch – high returns generally come with higher risk – a deep understanding of risk and return will awaken investors to a smorgasbord of investment options and Vues that they can mix and match to construct a portfolio that generates the returns they need with the appropriate risk.
Diversify your investment portfolio by investing into global thematic portfolios.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.