Economics,  Financial planning,  Investing,  Markets

The best way to manage risk in your portfolio

Investing is not just about getting the best returns you can, it’s about getting the best returns for the risk you’re prepared to take. That’s a really important difference and there’s an old saying in wealth management that the optimal portfolio is the one that lets you sleep best at night, and depending on the investor, that could be a portfolio that’s invested 100% in equities, or 30%.

The old adage that you should never put all your eggs in the one basket is a great one for investors to be mindful of. The most basic expression of that when it comes to your portfolio is referred to as ‘asset allocation’, which lies at the heart of every well-constructed, diversified portfolio and refers to how much of your portfolio you put into assets such as shares, property, bonds, or cash, and beyond that, how much you put into Australian assets versus international.

At the core of your asset allocation decision is how much risk you’re prepared to take and what your objectives are for your portfolio. Vanguard studied the returns of 600 Australian balanced funds over 25 years and found that asset allocation accounted for almost 90% of the risk and return outcomes, with specific investments and market timing making up the rest. Yet most investors who look after their own portfolio tend to focus the other way around.

The colorful table below ranks the returns of seven different asset classes (Australian equities, Developed Market equities, Emerging Market equities, REITS (property trusts), Australian fixed income, Global fixed income and cash) over the past 15 years, as well as the returns for a portfolio allocated 60% to growth assets, like shares and property, and 40% in defensive fixed income assets. The first four columns list the lowest and highest returns for each asset class, what the annualized returns have been and the average volatility per year (the average ups and downs as measured by standard deviation). The right side of the table ranks the returns for each asset class over the 15 years.

There’s a lot of information to take away from this table. Hopefully the first thing you’ll notice is the annual rankings jump all over the place, there’s no pattern at all, and what’s top of the pile one year can often be close to the bottom the next. That’s a reminder that returns from any particular asset class are what’s called a ‘random walk’, which makes them almost impossible to accurately and consistently forecast.

The next take away is the enormous range the asset classes have traded in. The average gap between the highest and the lowest returns per year is more than 30%, and the range within each asset class over the 15 years is amazing: for Australian and Developed equities it’s more than 70%, and for Emerging Markets and REITS it’s more than 80%! So if you consider yourself to be a pretty conservative investor but your portfolio’s chock full of Australian equities, you’d better be prepared to buckle up for a bumpy ride.

The final takeaway is the blended portfolio’s returns are far less volatile; you’ll never get bragging rights at the barbeque, but nor will you ever be left feeling like the dunce of the class. Compared to a portfolio full of Australian equities, you trade a return that’s only 8% lower but 29% less volatile.

Another common issue for investors is dealing with that sense of foreboding that having had a great year of returns last year we must be due for a lousy year to drag us back to the average, so maybe you should reduce your allocation to growth assets. Looking at the Australian market since 1936, there have been 17 years with a return of greater than 20% (including last year), and six of those years were followed by positive returns with an average rise of 25%! The 10 years where the market fell averaged a drop of 11% (you’re right, that adds to 16 years, but we don’t know how 2020 has panned out yet).

The table below shows the returns following a strong yearly rise are as unpredictable as asset class returns from year to year, but it also shows when the market goes up the gains are much bigger than the falls. And in case you’re wondering, the same holds true for US shares.

That’s not to say there’s no point making any changes, however, they should be based on valuations, not hunches. For example, the US share markets crushed the rest of the world over the past 10 years, with annual returns of 14.6%, compared to Australia’s 10.4%, but during which its Cyclically Adjusted PE ratio‘s gone from 14 to 31. That’s taken the US’s weighting in the MSCI All Countries World Index to 57%, while its share of global GDP is only 24%. The last time there was a disparity like that was in 1988 when Japan was 44% of the index with 17% of world GDP, right before it lost almost 80% over the next 23 years.

I’m definitely not saying I expect the US to do the same, but I am saying valuations matter, and your asset allocation should reflect that.

This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product.

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