When we talk about investments, in general, we also have to talk about the risk of those investments. In fact, this issue of “risk” is one of the things that most puts people off the world of investments, since, out of total ignorance, people associate “risk” with “losing all your money” and this can be far from the truth.
In this article we’re going to delve deeper into this subject and really understand what investment risk is and how we can best manage it.
What is risk?
Usually, when we talk about “investment risk”, we associate it with one of two things: the volatility of the investment or the likelihood of losing money.
Starting with the former, volatility is a statistical measure that is directly related to the variation of something. Applying it to the case of investments, if you have a product that rises and falls in price very regularly, then it is said to be highly volatile. For example, the stock market is, by default, highly volatile since, despite normally having an upward or downward trend over the long term, shares rise and fall in price several times a day. On the other hand, the money we have in term deposits is not volatile at all as there is no variation. The money we put there is and always will be that. The truth is that although the number is the same, its value will change, but we’ll talk about that later.
On the other hand, we can talk about investment risk from the perspective of the likelihood of losing money, and here the assessment is already more subjective. Using the example of shares we talked about earlier, if I invest in a start-up I’m more likely to lose money than if I invest in Coca-Cola ($KO), or any other company that has been around for decades. In both cases, I have the same type of product, i.e. shares, but the underlying asset is quite different.
Risk, then, is a mixture of these two paragraphs and something we have to find a way to live with as investors, since it’s something that will be constantly present in our lives. There is absolutely nothing wrong with risk in itself. We simply have to learn to manage it properly.
The illusion of “no risk”
When we talk about traditional savings products such as term deposits or savings certificates, we usually see the expression “guaranteed capital” giving us the feeling that that money is protected and will never lose its value. Unfortunately, this is far from true and that money is also at risk of being lost.
Please note that “guaranteed capital” is a real thing and the Deposit Guarantee Fund, for example, is there for exactly that. It exists to guarantee that if I put €10,000 in a term deposit, I’ll always have €10,000 available to withdraw even if things go wrong.
So where is this illusion of no risk? Well, if we go back through the article and look at the question of risk as the “probability of losing money”, then our €10,000 is at risk because of something very simple that is now all over the media, called “inflation”. This word, which was unheard of for several years, now appears everywhere and is felt in our wallets. If inflation is running at 8 per cent, for example, that means that I’m spending, on average, of course, 8 per cent more to buy what I was buying before. Let’s put it another way: our money is worth 8 per cent less today than it was before, right? So our €10,000 in the term deposit is able to buy fewer things today than it did before. Looking at it this way, we’re losing money! Even with the “stamp” of guaranteed capital!
So if even supposedly “risk-free” products aren’t, how can we create a savings and investment portfolio that helps us manage risk?
The answer: Diversification
Diversification is a more formalised form of an expression we all know: “don’t put all your eggs in one basket”. It’s as simple as that.
Having a diversified savings and investment portfolio then means that we should have various types of assets, different markets, with different returns and volatilities, in the hope that the average of all this will give us some peace of mind in the way we invest our money and the hope that we can, at any given time, be making money in some way or at least minimising our losses.
The issue of diversification is very complex and there are different ways of approaching it, but I’m going to share my opinion on the subject, which is closely related to another statistical measure called “correlation”.
Correlation measures the dependence between two variables, i.e. what happens to variable X when variable Y changes. Applied to the world of investments, this translates into what happens to market/asset/product X when market/asset/product Y goes up or down. And why is it important to know and analyse this? Simply because all markets are cyclical, they all have good and bad times, but usually at different times. We must never forget that the reason markets go up or down is because of where investors are putting their money.
If they’re putting their money into product X, then they’re not putting it into product Y. As we still lack the ability to guess what the rest of the world is doing with its money, the solution is, in my opinion, simple: invest in all asset classes at all times and thereby increase your chances of making money!
From the analysis I have done and which I apply to my own portfolio, there are 5 asset classes that have negative correlations and therefore form a diversified portfolio: safe capital, bonds, precious metals, shares and property.
Of course, there are several ways to invest in each of these classes, but in this article we’ll leave those details out.
For now, let’s just stick with this idea about the importance of diversification and all the advantages it can bring to your portfolio. It’s then up to each investor to better understand how to adapt diversification to their portfolio. However, in this article, I’m going to share two ideas that might inspire you.
Strategies
Now that we know what risk is and how important it is in our portfolio, let’s look at two basic strategies that we can apply to our portfolio. As I mentioned in the previous point, these strategies should only be seen as possibilities or inspiration and never as absolute truths. Having a more financially literate country also depends on each of us being able to make completely independent and conscious decisions, and never blindly following the tips and strategies of others.
Fixed portfolio
In this type of strategy, we establish from the outset the percentage of our portfolio we want to allocate to each of the asset classes and then we manage our withdrawals and withdrawals in such a way as to maintain these previously defined percentages, so that the percentages remain identical.
One of the most famous examples of this type of strategy is the All Weather Portfolio created by the mythical and successful investor Ray Dalio. This portfolio is divided into 3 large groups: 55% bonds, 30% shares and 15% commodities and has achieved an annualised return of close to 7.5%, which is quite attractive considering that it is, in my opinion, a fairly conservative portfolio with more than half of the portfolio allocated to bonds. For reference, the S&P500 index has an average annualised return of close to 10%, but because it’s purely stock-related it has much higher volatility and may be unsuitable for some people.
In my opinion, there’s a great advantage to this strategy: it’s very simple to apply. We have our target percentages and all we have to do is monitor the values. Have the shares gone up in value and weigh more than 30 per cent of the total? Then we might have to sell some. Bonds have fallen in value and are worth less than 55% of the portfolio? Then we might have to reinforce them. It’s really quite simple.
However, there are also, in my opinion, some disadvantages. We know that risk management varies from person to person, but I still think that the strategy, being fixed, becomes too conservative for young people and too risky for older people. In addition, it excludes capital insurance products, for the so-called “emergency fund”. Finally, for those just starting out, it may be too big and complex a step to begin their investing career in this structured way.
For all these reasons, let’s talk about another possibility.
Variable portfolio
Unlike a fixed strategy, having a variable portfolio means you have the freedom to adapt it throughout your life and according to the situation you’re in.
In this case, we discard the closed percentages by asset class. The only “rule”, if you can call it that, is that the portfolio has products from the five classes we talked about earlier: safe capital, bonds, precious metals, shares and property. For a more conservative investor, you could have a larger part allocated to the first two, while for a more dynamic investor, a larger allocation to shares might make more sense. It all depends on your knowledge, availability, resources and life in general.
One approach I particularly like, and which I follow in my own investment portfolio, is to gradually reduce the volatility of the portfolio as I get older. We know that the market is more generous to those who invest for the long term, so making an investment at the age of 20 is different, or at least should be, to making an investment at the age of 50.
To manage this more objectively, I like to use the Synthetic Risk Reward Index as this is a very simple way of understanding the volatility of various products. In fact, many of the products that are marketed today mention this scale as a way of immediately visualising the volatility we will be subject to, without much calculation. In the Savings and Investment Masterclass I talk in detail about this variable risk management strategy and how we can apply it to our investment portfolios.
Conclusion
Risk management is a topic, like almost all in the world of finance, that gives rise to much discussion and that each investor sees differently. The only thing I’m sure of is that we should only invest in what we understand 100 per cent and that makes sense to us, regardless of what we read or are told. Of course we should use these sources of information to learn and evolve, but we should only use them to inform our own choices and decisions. It’s our money and we, better than anyone, know what we want to do with it.
The Web Economist 