Risk and investment strategy

If you remember investing in the 1980s, you probably remember when deposit accounts paid a handsome rate of return. Nowadays we are all too familiar with rock bottom interest rates. This coupled with the fact inflation erodes the true value of cash over time, means we tend to look to the markets, and most notably equities to get real growth on our capital. But with the turmoil and volatility we have experienced over the last 12 months it is understandable that market sentiment is not overly high. Even the experienced individual investor is somewhat cautious.

So what has lead to this recent volatility? Well, it truly is a global story of macroeconomics. Stretching from the streets of Shanghai, where stock investing has become a middle-class sport, from the unrest in Europe, to the Federal Reserve in Washington.

Today, it is right to say that Macro-economic developments and the dynamic external environment have led to a significant change in the way we think and deal with our finances, with the consideration of risk at the forefront of most retail investor’s minds.

The first and most important thing to remember about risk is that it is dynamic. That is, it appears and disappears. When times are good, risk seems to vanish. When things are more difficult, risk seems to be all that we think about. Now more so than ever investors are rethinking their overall approach to portfolio construction and thinking much more about diversification, in an attempt to gain exposure to different non-correlated types of risk.  With risk really being centric to the decision making process, there are two main areas to consider, that of asset allocation and investment strategy. Lets take each of these in turn:

There are an array of views on investment strategies, but probably the most famous is that of Modern Portfolio theory, or MPT, as it is better known. MPT was first invented by Harry Malcowitz in 1952.  In a nutshell, he suggested that investors should select portfolios rather than select individual securities. The Modern Portfolio theory suggests that instead of looking at the risks of individual stocks, you instead measure how they all react with each other and then calculate the risks inherent with your overall portfolio.

Many years on and investment strategies are evolving. If you’re an investor that adopts a top-down approach, then the recent volatility is likely to be of concern to you. You will be looking at the big picture, which in practical terms means thinking about what the political and economic conditions are telling you. If you are a Bottom-up investor then the recent volatility won’t concern you as much.  You are more focused on specific stocks. This means picking companies you think will perform well in the future and then holding onto them, regardless of the broader economic climate.

Others will adopt the Core and Satellite approach to investing, where a separate portfolio of investments are split into two distinct segments: core and satellite.  Holding a core of long- term investments, with other more specialist or shorter-term satellite investments.

Strategic asset allocation describes the practice of creating a portfolio with a mix of assets designed to fit the investment parameters of the investor. A key assumption is that those parameters will remain relatively stable over the long term. Frequently referred to as buy-and-hold investing.

Tactical allocation essentially adjusts around changing market conditions subject to forecasts, whims and guesses. The premise is that by doing this, one can optimize market exposure to best maximize risk-adjusted returns, although its success is often questioned. We are all familiar with the saying ‘its about time in the market’. In this regard it’s worth noting that many portfolio managers do not attempt to follow a timing strategy. For most investors the approach is to stay invested and over the medium to long term. In theory market timing is brilliant, but in practice it just doesn’t work successfully for most investors. Most experienced investors understand that the key to long- term success lies in strategic allocation and that picking funds or trying to time the market is nearly impossible.

Warren Buffett has spent his life dispensing advice, earning him the nickname of the Oracle of Omaha. His wisdom was distilled through the Berkshire Hathaway annual meeting, where he quotes “Successful Investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time”