DIY Investor Magazine
/
March 2017
22
HOW MUCH RISK CAN YOU TOLERATE AND HOW DOES THAT
AFFECT YOUR INVESTMENT PORTFOLIO?
It’s difficult to over-egg it - investment decisions are
important; whether you are taking financial advice,
investing via an automated investment platform or
making individual investments yourself, your success or
otherwise can have a material impact upon the quality
of your life and your ability to achieve your financial
life-goals - Muckler looks at why it is important to
know where you really sit on the risk/reward curve and
what that means in terms of the construction of your
investment portfolio.
I suspect that, in the same way we became acquainted
with ‘supply and demand’, at the risk of betraying my
vintage, ‘risk and reward’ probably entered our lexicon
at O’level time.
And it all makes perfect sense; the more risk you are
prepared to take the greater the potential reward and
the greater your potential for loss. Even ‘no risk’ –
putting your money in a sock - comes with the risk that
its buying power will be eroded over time by inflation.
Advisers, human or otherwise assess your appetite
for risk based upon a range of questions and you will
find that you are a ‘3’ or a ‘5’ which in turn suggests an
asset allocation that is right for you; but where does
a churning stomach or night-sweats appear on the
spectrum as you fret over a volatile market or change in
personal circumstances?
Risk in the context of asset allocation is broadly the
balance of shares (no guarantees, potential volatility)
and bonds (guaranteed income, greater stability) in your
portfolio.
A correct assessment of your appetite to risk can
prevent an emotional and expensive ‘sell’ response
when markets fall, and whilst filling in a questionnaire
may churn out a ‘score’ you may only really ‘feel’ what
your level of exposure is when markets turn bearish.
LEARN FROM THE PAST
Markets are cyclical and even if you have not
experienced a 20% downturn in the value of your
portfolio, there will be someone willing and able to share
their experience.
One of the most damaging and costly reactions to
a downturn is a knee-jerk sell off which will almost
certainly be done at a knock down price; whist emotion
can never be fully excluded, this can be controlled with
a risk assessed asset allocation.
If anything it is probably better by starting off too
cautiously; taking a hefty blow to an equity rich portfolio
may ward the investor off the asset class for good,
thereby depriving them of the inevitable gains that will
be along at some point in the cycle and leaving too
much heavy lifting for the bonds to be able to meet the
investment objective.
In response to a 20% downturn:
•
If you panicked and sold up then your asset
allocation is too aggressive; you are likely to have a
low or very low tolerance for risk and should reduce
the proportion of equities you hold in favour of fixed
income – bonds.
•
If you were worried but held firm without undue
duress, you probably have a moderate appetite for
risk that can cope with that level of loss.
•
If you saw the downturn as an opportunity to pick
up equities at knock down prices, then your risk
tolerance is high.
•
If you hoped for further falls to throw up more
bargains, you have a very high tolerance!
William Bernstein in ‘The Investor’s Manifesto’ suggests
the following when constructing a risk-assessed
investment portfolio:
Your bond allocation in percentage terms should equal
your age; older = safer.
‘EVEN ‘NO RISK’ – PUTTING YOUR MONEY IN A SOCK -
COMES WITH THE RISK THAT ITS BUYING POWER WILL
BE ERODED OVER TIME BY INFLATION’
