The risk of playing it safe

When investors think about risk, they usually think about losing money. But there is another risk that receives far less attention: not taking enough risk to achieve what they set out to achieve. A portfolio can therefore feel safe and still involve risk. Managing risk is not simply about how much volatility can be removed. Instead, it is about weighing which risks an investor can afford to take (or not take), if they are to achieve their objectives.

Classifying risks correctly is especially important in the current environment

The temptation to play it safe is understandable. Geopolitical uncertainty, persistent inflation and the end of the easy money era are making markets feel less predictable. Nevertheless, investors still need to protect and grow their wealth despite this uncertainty.

The dilemma is that actions which reduce discomfort today can increase the risk of falling short tomorrow. Holding more cash or reducing growth exposure may make a portfolio feel more stable, but over a longer time horizon capital may grow too slowly to keep pace with inflation or the investor’s objective.

Uncertainty therefore does not remove the need to take risk. It makes it more important to identify which risks are necessary, which are avoidable, and which could cause permanent harm to the investor’s portfolio.

Risk should be defined by the objective

Volatility matters, particularly when it translates into losses that are large enough to permanently impair capital or cause investors to abandon their plans at the wrong time. However, volatility does not provide a complete definition of risk. A low-volatility portfolio that fails to preserve purchasing power or build sufficient capital is not safe in any meaningful sense.

Risk should instead be judged against the investor’s objective. It is the possibility that the portfolio fails to deliver what the investor ultimately needs. Good risk management must therefore address both sides of the problem: limiting losses that can derail the plan, while retaining enough exposure to growth assets to ensure the client has a realistic chance of succeeding in reaching their objectives.

What this means for portfolio construction

Defining risk in this way changes the approach to portfolio construction. The task is not simply to minimise each asset’s volatility. It is to combine assets so that the portfolio can withstand a range of outcomes while still delivering sufficient returns to reach the investor’s objective. The deep-seated unwinding of imbalances that have accumulated since the Global Financial Crisis (GFC) means that historical relationships between asset classes can no longer be assumed to provide the same level of diversification as in the past. Furthermore, separate asset-class silos can obscure the economic risks that different investments share.

For example, rising interest rates can affect both banking shares and local bonds. Looking at each allocation independently may understate the portfolio’s total exposure to the same underlying risk. An integrated approach considers how assets interact across the whole portfolio, with the aim of limiting concentration risks while providing access to a broad range of portfolio options.

Peace of mind comes from addressing both risks

Peace of mind should not come from removing as much volatility as possible. It should come from knowing that the portfolio addresses both risks: the risk of damaging losses, and the risk of failing to grow enough. The aim is to distinguish between noise that can be tolerated, risks that must be managed, and growth that needs to be achieved. The safest portfolio is therefore not necessarily the least volatile one. It is the one best positioned to achieve the investor’s objectives without exposing them to risks they cannot afford to take.

See how our integrated portfolio approach puts this thinking into practice

Lyle Sankar is the Chief Executive Officer at PSG Asset Management.