Risk and Return. This is a universal law which cannot be disputed. Like the law of gravity, it always works. Just like when we throw a ball into the air, it will always return to the ground. Likewise, if we want more returns on our investment, we will have to undertake more risk. Like the old adage, “There is no free lunch in this world”, the risk is directly proportional to the return we will achieve.
In amassing wealth, we will also need to manage the wealth with wisdom. There are people who can amass wealth overnight with their brilliance in investing or by a stroke of good fortune, but unfortunately, they do not have the wisdom and character to keep the wealth and very soon, they are back to where they started off. We need to understand this fundamental principle of risk and return in order for us to preserve our capital which we have accumulated and enhance its return, growing our portfolio to the next level of wealth.
We have discussed risk management for life previously and I shall now focus on investment risk management. The most effective key in reducing investment risks is diversification. Diversification is when we created a portfolio of various asset classes, for example, stocks (equity), bonds (fixed income), property (real estate), futures and options (derivatives), and other classes. Within the asset class, we can further diversify into different sectors and countries. This is called the level of diversification.
When we invest in the stock of a particular company, for example, Microsoft, we are taking the risk of the company, its sector, the country which it operates, and the global economy. The risk of the company will include the quality of its managers, the health of its financial statements and its business model. The sector risk will be the industry performance as a whole, in this case, is the information technology industry. The country risk will be USA, as the business primarily operates there. And finally, the global risk will also affect Microsoft since USA is part of the global economy.
However, when we include Apple Computers into our portfolio also, we will eliminate company risk to a large extent. Reason is that if Microsoft share price declines, Apple shares may be increasing due to a superior product. However, if a bad news hits the IT industry, both of them may face share price decline. Thus we can also include other industries into our portfolio, for example, Kraft Foods in the food industry which is not correlated to the IT industry.
We can protect the downside of our investment portfolio also, if we invest into other countries besides USA. If USA is facing a national recession, we may have investments in other countries for example China to sustain the portfolio.
The risks that we are eliminating in the previous methods are non-systematic risks. If we ensure that our investment portfolio has a healthy allocation of funds into the different asset classes and sectors, which are fairly correlated negatively to each other, our portfolio should not sustain much market shocks. There are, however, systematic risks which affects the whole global economy that cannot be diversified away. We can do our best to diversify into other asset classes which have different behaviors to economic indicators, but we will still be exposed to systematic risks to a certain extent.
Now that we understand how to preserve capital by diversification, we need also to understand asset allocation to enhance returns while preserving capital. The first step to this process is to understand our risk profile. A high risk taker will allocate his portfolio into very sector specific or even single companies, while low risk taker will have very diversified portfolios, with much into bonds and other low risk instruments. A moderate risk taker will usually have a hybrid of both.
Asset allocation is a very dynamic process and there are numerous books written on this subject. In essence, asset allocation uses the different characteristics of investment instruments to create a portfolio that is diversified. The different instruments will be negatively correlated to reduce the risk. However, the returns will also be moderated due to the lower risk. The art is to have an optimal allocation such that with the risk the investor is able to undertake, he is also able achieve the highest return. Asset allocation is also dynamic with reference to the markets. In different investment climates, allocations will be different. For example, in the climate where interest rates are high, an investor will most probably move more allocations into equities instead of bonds, as bond prices generally decline when interest rates are high, and vice versa.
Therefore, in order to preserve the wealth that we have accumulated and enhance the returns for capital appreciation, we need to understand these important principles. Risk and return, diversification and asset allocation, will serve as very useful principles when we manage our wealth with wisdom. The learning of these principles is not exhaustive, and I will encourage you to keep on upgrading your knowledge of these concepts, and the rewards will be invaluable.
Aaron Graham Tay, CFP
