Understanding your risk tolerance

Understanding your risk tolerance

Many investors become overly anxious when markets behave badly and choose to sell off valuable stakes of their portfolio. However, opting to sell when values decline is rarely a good idea. Panic-selling or buying almost always ends badly, which is why investors must understand the dangers of changing strategy in a portfolio in hopes of chasing past performance. And why proper risk profiling will help ensure that your asset allocation is aligned to your current situation and risk appetite.

In financial terms, risk is defined as the possibility of having a different outcome or investment return than what was expected. Risk includes the possibility of losing some, or all, of an original investment. So, the word ‘risk’ inherently holds negative connotations – it alludes to an exposure to loss. However, I’d argue that the framing of risk is often misguided by short–termism at the expense of long-term goals. All types of investments require that you take on some degree of risk, but once we truly understand what is at risk, investors will not be swayed by behavioural biases. They can then make informed decisions that are aligned to portfolio benchmarks, which will help them achieve their financial goals.

The determinants of a risk profile
In the simplest form, to determine an investor’s risk tolerance, two broad questions will be asked: (1) “how much upside do you want?” and (2) “how much downside can you tolerate?” Generally, no-one wants any downside over any period, but managed risk needs to be introduced into investors’ portfolios in order to realise returns that beat inflation. There is also a third element that helps frame the upside expectation and downside tolerance – time horizon. From an unbiased perspective, these are reasonably easy to plan for. However, it’s often hard to really know what risk you are comfortable with until you’ve experienced the volatility that markets typically deliver in the short term. It is therefore important to make an honest assessment of your own risk tolerance with the help of a financial adviser. Risk profiling can help you understand your underlying attitudes towards investing and consequently help predict your probable reactions to future events. This is an important part of the financial planning process. You can then invest in portfolios optimised and diversified to reach your personal set of investment goals.

What is really at risk?
They say hindsight is 20/20. Well, that was certainly true for the last year - 2020 saw the fastest sell off in equity markets and the fastest recovery ever. At its lowest point investors in local equities lost 40%, however the one-year return on equities ended 7% up (almost double inflation for the year). In hindsight, those who chose to stay invested in equities through the turbulence managed to beat inflation and reap good returns.

Investors need to understand that they may well be invested during those times of downsides and volatility of markets, and framing around how this will impact their investments. If you can accept that you will experience a negative return in equities (around 20%) at least one year of every five-year period, then the recent experience is a good one to frame one’s expectations of equities:

In the short term (five years)
The returns of South African equity have been lower than normal. However, it has beaten cash, and those investors who stayed invested over the five-year period are already on their journey to achieving the benefits of compounding interest. The extra return over cash delivered by South African equities was 16%.
In the medium term (10 years)
Investors in the South African equity market over the last 10 years have reaped the benefits of compounding, with a cumulative extra return on investment delivering almost double the returns of a cash investment, at 92.5% (see Graph 1).
In the long term (>10 years)
The case for being invested in growth assets makes any lower risk investment seem very unattractive. Getting nine times extra return over cash makes a lower risk asset a very unappealing alternative.

Graph 1: Annualised returns – equities vs cash

Source: Morningstar Direct

Time horizon is crucial: the longer the time horizon, the less volatile returns from equities becomes, in other words, the expected returns one can plan for becomes more reliable. One of our funds, the PSG Wealth Creator FoF can be used to illustrate this example (see Graph 2). By staying invested long enough (seven years plus), your returns will be able to achieve the cash and inflation beating returns expected from equities and deliver the power of compounding. Through the planning process there may be shorter-term capital and income needs, which may not make a portfolio fully exposed to growth assets appropriate, and that appropriateness needs to be decided on – this is precisely why engaging with a qualified financial planner is key to good financial planning.

PSG Wealth Creator FOF D – the best, worst and average in rolling returns

Source: PSG Wealth multi-management research