As investors continue to be buffeted by uncertainties in the market, the importance of an appropriate, disciplined and strategic investment strategy is increasingly evident. Emotions are among an investor’s biggest enemies, particularly when faced with challenging and unpredictable events.
Discipline and commitment to a long-term financial plan are vital and will eliminate many of the risks lining the path of any investor. As part of such a plan, a clear understanding of your personal risk appetite is essential in order to fully grasp the concept of risk.
What is risk?
Risk is definitely not just another pesky four-letter word. For most of us risk means the possibility of losing something. Risk, it can be argued, is the result of information that is incomplete or lacking. If we all had perfect foresight, there would be no risk in anything.
To summarise, risk is:
- The quality or state of being in doubt or lack of sureness
- The possibility that a future event may cause harm or the possibility of loss
- The danger of not achieving one’s goal, and therefore the deviation from the expected.
Any activity that has an inherent danger often has associated rewards to compensate for that danger. For example, the risk of bungee jumping off a bridge is rewarded with the huge adrenalin rush experienced by the jumper.
Therefore, we would expect there to be a positive relationship between risk and reward or, in investment lingo, between risk and return. So, the absence of risk equates to the absence of return and, similarly, without taking risks we cannot obtain returns.
Manage your expectations
Every investor seeking return – whether for retirement, further studies, preservation of capital or income generation – should really take the time to get to know and understand their risk preference, before they invest a cent. Once you fully understand how you view risk, you will know where and how much to invest and what return to expect. It will also enable you to manage your future expectations and expenditure.
Risk means different things to different people. Most investors will agree that losses of a given magnitude produce a pain more acute than the satisfaction produced by gains of a similar magnitude. This is often the reason why investors feel overconfident and then expose themselves to the recent best-performing asset class or manager (probably at the wrong time) and remain leery of the worst-performing asset class or manager.
Some investors are concerned about relative risk (underperforming a benchmark or target) and others might be concerned about absolute risk (losing money). Therefore, some investors might be worried about their real drawdown (maximum loss below inflation), others might want to minimise their portfolio’s shortfall to a benchmark and others might want to reduce their value at risk. Clearly, the definition of risk is extremely important and each and every investor should be comfortable with their risk preference.
Setting a target
In determining your risk preference, you need to carefully consider factors such as investment time horizon, type of investment vehicle, required market participation and future cash flow requirements. The goal or target set by the investor also plays a crucial role. This target could be inflation (wealth preservation), zero (capital preservation) or an absolute/relative value.
Investors should consider the following criteria in determining their target and goals:
- Liquidity. This is defined as the funds required by the investor to cover expenditure over a short period of time.
- Income. This reflects the cash flow needs anticipated by the investor to maintain their lifestyle.
- Capital preservation. This relates to the need for an investor to avoid experiencing a significant decline in the value of their capital.
- Growth. This reflects the need to see capital appreciate over time.
Finally, investor’s risk preference will be influenced by the type of investor they are. Broadly speaking, investors can be divided into those seeking to grow wealth (mostly preretirement individuals) and those seeking to preserve wealth (mostly retired).
Knowing your personal risk appetite is an important factor in determining what role risk will play in your investment strategy. Once you have considered it, you will be in a better position to develop and commit to your long-term financial plan.
Maarten Ackerman is chief economist and advisory partner at Citadel.