Why Now Is The Time To Think About Investment Risk

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Why now is the time to think about investment strategies and risk.

Reflecting on the past 6 months, particularly since the effect of Coronavirus on financial markets, I am concerned that many investors do not have a clear and tailored investment strategy. My observations are that investors seem to be failing to understand one basic investment principle; 'The higher the return the higher the risk’.

In many instances there remains a significant misalignment between the investor’s risk profiles and the investment risk connected with their investment portfolio.

The next 12 to 24 months will experience further challenges and headwind in investment markets, with investors seemingly not factoring in the risk of recession and downturn in markets.

Investors are investing without a strategy or plan that is reflective of their goals and objectives and their personal financial circumstances. Instead, investors are focused on maximizing returns and the index benchmark. In a low investment yield environment, investors are focused on higher returns without considering the associated risk.

Therefore, investors may be taking on more risk than is necessary to achieve their desired outcome.

INVESTMENT PHILOSOPHY

Our Investment Philosophy centres on:

Investing with the view to minimise the likelihood of losses, thereby focusing on preservation of capital;
Ensuring the investment reflects the level of return for the risk taken, and;
Focusing on achieving the highest return for the level of risk prepared to take, not solely the highest return.

Risk simply means the probability of a negative outcome occurring.

RISK PROFILING

When addressing an investor’s risk profile, two factors are relevant:

Risk tolerance

“What keeps you awake at night?”
The investor’s attitude and feeling about risk and the possibility of making a loss.

Ability to absorb risk

Notwithstanding an investors risk tolerance, the ability of the investor to absorb a correction in investment markets or an underperforming asset.

Factors to consider when considering the ability to absorb risk

The investors are retired and cannot add to the investment pool;
The investors are reliant on investment income for their lifestyle;
The investors cannot afford capital losses as they are reliant on the drawdown of capital, and;
The asset is a large proportion of overall wealth.

Investors also fail to consider the effect of ill health or the death of the investment decision maker.

As Investors approach retirement, it is crucial the investment portfolio is reviewed to ensure the investment remains relevant and appropriate for retirement. In particular, it is important to consider the following:

Investment returns are sufficient to sustain living requirements;
Liquidity and the ability to readily access cash funds, and;
Time commitment and resources to maintain the Investment.

It is important to consider if the investor is drawing a pension from superannuation during a market downturn as it may be difficult to recover losses. The principle of ‘stay in the market’ to recover losses may be difficult to achieve.

Developing your Investment Strategy

When developing an Investment Strategy, target the risk appetite first and then work within that framework to achieve the desired return. The wealth and financial strategy can then be centred around the outcome of this analysis.

If an investor can achieve their financial goals with lower returns and less risk, why seek high returns with high risk?
One possible answer may be the investor can absorb the risk with no material effect on immediate or further required income.

Otherwise, investors take a high investment risk when they are not in a position to absorb the risk due to:

Being unaware of the risk;
Not understanding or considering the actual effect of negative returns on their financial wellbeing, and;
Investor greed.

Goal Based Investment

We focus investment strategies on ‘Goal Based Investing’, not simply focusing on maximizing returns or comparing returns against index benchmarks or the performance of other Investment Funds.

We endeavour to assist investors align their risk profile with their investment behaviour.

Investment Case Study

OVERVIEW
Prior to the Coronavirus, we were reviewing a Clients’ investment portfolio in preparation for their retirement.

The Clients clearly had a conservative investor profile, both from a Risk Tolerance and Risk Absorption perspective:

All investments were in Australian listed equities;
A conservative portfolio model would be 15% growth, 85% defensive;
Defensive investments would be cash, and fixed interest securities;
Growth investments would be Australian equities, property and global securities;

The Clients’ actual portfolio was more reflective of a High Growth model, with all the associated investment risk:

A High Growth Portfolio would be 90% growth assets and 10% defensive assets.

When discussing the investment portfolio with the Clients, we recommended that the investment portfolio be re-balanced towards a conservative investment model. A conservative investment model returns would sustain their lifestyle and meet their financial goals into and beyond retirement.

The Client’s had not considered the ‘risk profile’ of their investment portfolio and at first instance were very concerned.

RISK ASSESSMENT
Without addressing their Investment Philosophy and developing an Investment strategy:

They were not aware and had not considered the associated risk of the investment portfolio;
Had not properly considered their investment goals and objective;
Not addressed the risk of their Investment Portfolio and the potential financial impact on their retirement plans, and;
They were investing for ‘highest’ returns with no consideration to Risk.

The Clients were not prepared to re-align their Risk Profile with their Investment Portfolio. They could not accept the idea of lower returns, despite the investment risk.

The downturn in the investment market due to Coronavirus reduced the Clients’ investment portfolio by over 30%.

Their conservative risk tolerance eventually overcame their investment behaviour, with the Clients exiting the Share Portfolio for cash, forcing them to place their retirement aspirations on hold.

Events such as a Coronavirus or unexpected downturns in the market cannot be predicted.

Whilst we cannot predict, we can prepare.

A properly considered investment strategy, reflective of the investors’ investment philosophy and personal circumstances, can prepare for unexpected events and assist in achieving financial wellbeing.

The Investment Strategy should:

Clearly articulate the investor’s financial goals and objectives;
Address the investor’s risk profile, both Risk Tolerance and Risk Absorption;
Address the liquidity and need to access funds, and;
Consider the age, health and life stage of the investor.

If you are concerned that you haven’t considered inherited investment risks in light of your personal risk profile or need assistance in compiling a relevant and considered investment strategy, please get in touch.

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