Investment Risk & Asset Allocation: The Basics
The biggest risk is not taking any risk… In a world that changing really quickly, the only strategy that is guaranteed to fail is not taking risks. — Mark Zuckerberg
We are all living in a world that has just about recovered from awful risk management decisions, such as the last financial crisis, but when it comes to investments, risk tolerances vary substantially, why is this? Well, it depends, how old are you? Where do you live? Who’s capital are you using? Institutions and Hedge Funds that have billions of other people’s AUM will approach their risk strategy differently to that of a retail investor using their own cash in a GIA.
When it’s their own cash at stake, RIs are far more likely to protect their positions over all else, opting for seemingly ‘risk free’ investments such as cash deposits and government bonds, but this low risk comes with the glaring typical drawback, low return. Not to say this is necessarily a bad thing, some return is better than nothing, and at least you are trying to balance the tables against the invisible force of inflation, but history has shown that without taking risks, you are far less likely to reap the rewards.
The other end of the risk spectrum can either be considered the promised lands, or you know, the terrifying abyss, depending on how your decisions pan out. High risk assets such as stocks, or even more so, with certain alternative investments, can turn your bag of sand into a money tree, but if you aren’t careful, you could be left holding the biggest bag of excrement in the playground. That being said, stocks are incredibly important foundations to any portfolio, and when you factor in historical price movements and dividends (also, see my friend’s DRIP piece), you’d be mad to exclude them.
What’s my age again?
There’s a reason why diversification is spoken about so much, and it’s to try to help cover you (or at least soften the blow) from depreciation in certain asset classes you might hold. Age determined asset allocation is a well trodden path of risk diversification, when you are younger, the theory is that you invest heavier into higher risk vehicles that generally have the best long-term returns (typically stocks) and less in lower risk classes that have less fluctuation (namely, bonds and cash), as even if you take a hit to your share holdings, the time you have ahead of you for them to recover should be able to sustain your portfolio till you need the capital in (most commonly) retirement. The general formula for this has been to hold a percentage of stocks equal to 100 minus your age, but in recent times this has been challenged due to variables like longer life expectancy.
TL;DR
All risk profiles are unique to the subject. Institutions may be more laissez faire towards risk, as it isn’t necessarily their money they are playing with, but if you’re a middle aged retail investor, planning to start betting your pension into volatile stocks or high risk unconvential assets, you should maybe go back to the spreadsheet and see if that is really for the best. Plan your tolerance for risk, study your risk adjusted returns, allocate according to your time frame, and don’t throw it all out of the window when your cabbie tells you about the next hot stock.
