EVERY investor aspires to earn the highest possible returns but this approach often ignores the need for an investor to first accept the volatility risk that comes with earning high returns.
It is best for investors, before making an investment, to ask themselves how much volatility they are able to withstand and work backwards to obtain a reasonable level of expected returns based on their risk appetite. If investors want higher returns, they should be prepared to take on greater volatility risk.
To better manage their expectations, investors first need to understand their behaviour towards volatility. This can be achieved by answering the following questions: the extent of losses one can bear in the short term before an investment earns a return; the time one has to stay invested; the need for the investment to provide immediate liquidity; familiarity with the investment and financial markets; available time for managing and learning about investments; and the expectations on returns.
Why is this important? Understanding oneself is a prerequisite to devising a personal investment plan and portfolio. Having a customised investment plan keeps the end objective of investing in focus.
It also helps counter pressure to go after what is hot in the market and avoid panic when markets suddenly turn downwards.
Aligning investment plans to risk profile
An investor can be generally classified into one of three risk behaviour profiles: aggressive, balanced and conservative.
An aggressive investor generally has the highest tolerance of volatility. He would, therefore, be comfortable staying invested in an instrument that may be making losses in the short term, but which could perform well in the longer run.
A conservative investor prefers minimal or no exposure to volatility and would be uncomfortable with short-term negative returns.
The profile of a balanced investor is between that of an aggressive and a conservative.
Once an investor has ascertained his risk behaviour profile, he can determine how much to invest in equities and fixed income or capital protected type of investments by adopting the “Strategic Asset Allocation” strategy. This tool forms the basis of allocating assets based on an investor’s risk profile independent of market condition (See Table 1).
An investor can maximise returns in the short to medium term by varying the allocation to each asset class, depending on the equity market environment. This can be done using the “Tactical Asset Allocation” strategy as shown in Table 2.
As the strategy requires active management of the portfolio, a great deal of insight and conjecture about the economy, financial markets and investments, investors are advised to work with financial advisers.
The next step is to select investment products in each asset class with attention to understanding the respective return, volatility and correlation profile with other investments.
As covered in the previous article, a superior portfolio is one that maximises return for a given level of volatility risk. That involves diversifying into various investments that have low or negative correlation to one another. Table 3 shows the various types of investments classified into different categories.
Given the current uncertain outlook for equities, investors should focus on investments that have less volatility in returns and low correlation to equity returns.
Examples of the former include fixed-income securities, under-researched growth stocks and structured products. And for the latter, commodities and foreign exchange.
Rebalancing portfolio
The final but often neglected or forgotten part to investing is to periodically re-balance the investment portfolio. Re-balancing involves buying and selling investments in the portfolio to bring the asset allocation for each asset class back to either the Strategic or the Tactical level.
Re-balancing automatically results in cutting back on performing investments and adding to under-performing investments, provided the case for investing in the latter is still valid.
Investing should involve proper planning, knowing one’s behaviour towards volatility and understanding the reasons for changes made in portfolio, because failure to do so could lead to unfulfilled expectation on investing.
Source: TheStar October 4, 2007
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