Risk versus Return – the age old dilemma
A central component of the portfolio construction process is the selection of asset classes to invest in and then how to best allocate your money across those different asset groups.
The decision essentially boils down to a trade off between risk and return.
More risky assets provide better returns over the long-term. Less risky assets provide less return, but also less worry, over the long-term.
Investing in a single asset class is risky when you consider no one asset class consistently outperforms on a regular basis.
The above table (Money Management Magazine, p28, September 6 2007) shows the average market return per annum across various asset classes for the 27 years from 1980 to 2006.
The red triangles highlight the worst performing asset class in each particular year, the blue triangles show the best performing asset class in the year. As you can see, these triangles are all over the shop, indicating just how hard it really is to ‘pick’ the winning asset class year on year.
The table also shows the average annual return of each asset class over this 27-year period and the average risk per annum that an investor takes to achieve this return.
The numbers show that the best performing asset classes over the past nearly three decades have been listed property trusts (LPTs) followed by Australian and international shares — a particularly good result for LPTs given their lower risk profile.
However as ever, past performance is unfortunately not an accurate indication of future performance and investors can’t necessarily expect this same outcome over the coming 27 years.
At the lower performing end are cash and Australian bonds — again reinforcing the mantra that lower risk equals lower return.
Russell InvestmentGroup believes the wise strategy is to diversify at all three levels.
By combining asset classes and fund managers with different styles in complementary ways, investors benefit regardless of which manager or asset class is in favour with the market.
While all investors have been suffering the stress of market volatility over the past month, those investors who are broadly diversified will have experienced less trauma than those solely invested in stocks or more aggressive fixed interest securities.
Peter Gunning is Chief Investment Officer Asia Pacific for Russell InvestmentGroup . He spoke on portfolio construction issues at the recent PortfolioConstruction Conference.
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