Is ‘risk free’ investment a risky strategy?

Despite strong performance from equity markets in Australia this year and improving economic data globally, uneasiness about risk persists. David Redford-Bell looks at how to achieve sustainable growth while effectively managing risk. 

Looking at the performance of equity markets over the past 12 months, you could be forgiven for wondering what investors have to be worried about. Returns of 20.51 per cent p.a. from the All Ordinaries Index for the 12 months to 12 November 2013 look good by anyone’s standards.  

Despite this, investors remain cautious, and for a number of reasons. The global financial crisis (GFC) – and the very real losses it caused – is still fresh in the minds of many.

Although most markets have regained the losses in the five years following the crisis, the prospect of watching their investments in free fall again is changing the way investors look at risk.  

Against that backdrop, we face the big questions: where should investors be looking to achieve the returns they require, with lower levels of risk?

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And how can advisers demonstrate the value gained from risk, in terms of investment budget, alongside value for money, in terms of fees? 

To answer these, we need to take a look at the current market environment and its impact on popular investment vehicle options. 

The flight to safety  

You need only look at the persistently high holdings of cash to see that the flight to ‘safety’ in terms of lower risk investments (also including fixed interest and cash equivalents) continues.

With capital values showing their volatile nature over the last five years, Australian and international investors have been more focused on income than ever before. 

As a consequence, increased demand for these kinds of investments has made them more expensive, and therefore reduced the relative levels of income they produce.

With official interest rates at historic lows for many investors – and particularly retirees who need a steady income – income-only strategies may not be able to deliver sustainable returns into the future. 

Indeed, for investors with an intermediate- to long-term horizon, which is to say beyond 12-18 months, fixed income only investments, such as bonds, may not offer real value in terms of growth once inflation is factored in – even at its current low levels.  

At the same time, effectively evaluating the potential risks and returns from other asset classes poses real difficulties for investors.

Risk is a multi-faceted conundrum. It can be difficult to assess the effect of different events on market dynamics now, let alone in the future. It’s not hard to see why defensive ‘low risk’ strategies are appealing. 

Can ‘risk free’ be risky? 

As we see from the current situation with fixed income, however, sometimes choosing to take the ‘risk-free’ option can be risky.

A slow death as capital is eaten away may have far more dire consequences than unexpected fluctuations in markets. Income lost in the short term as a result of market turbulence is certainly not welcome, but needs to be weighed up against capital that is eroded over time. 

The bottom line? Many investors are not likely to have sufficient funds to live on when they retire, full stop. Which means they will need to take educated risks in order to generate the returns they need.   

So is the answer higher risk investments – with potentially correspondingly higher returns? 

Unfortunately it’s not that simple. Yes, higher risk can bring higher returns. However, higher risk also means just that: higher risk. There are no guarantees. And tales of big losses are many and varied. Which brings us to equities. 

The trouble with equities 

It is fair to say that over a long-term time horizon (five years or more), equities have traditionally provided reasonable, risk-adjusted returns to investors in terms of income and growth. 

The price investors pay for this is volatility, and it can be significant, particularly in the short-term. Twelve month returns over the last 10 years have varied between negative 38 per cent in 2008 and positive 37 per cent in 2009 for the ASX 200 accumulation index. This is a huge variance in returns, particularly if you are relying on your capital to pay for living expenses. 

In addition, financial commentary in Australia is so heavily skewed to equities that some investors see them as a proxy for investment markets as a whole.

This can lead many investors to mistakenly believe that if equity markets fall by 20 per cent, then their investment portfolio must have fallen by a similar amount.  

This is often compounded by a sensationalist media hungry for the next disaster story, as well as “information overload” from a number of sources. As investors, we have never faced a wall of so much information with so little context. 

So, while equities may get investors where they want to go in the end, they may need to roll with too many punches along the way.

For investors nervous about seeing their portfolio value fluctuate in the short term, or without the resources to withstand short-term volatility, equities may not be the best option.  

True diversification is key 

So if equities aren’t the answer, is there a way of achieving reasonable returns, with lower levels of risk? 

Most financial commentators agree that the best way to mitigate risk, while maintaining an exposure to growth, is through diversification.

A portfolio made up of different asset classes is more likely to have a lower risk profile than its single asset counterpart. And add to that portfolio the global opportunities on offer from international markets, and the diversification effect is stronger still.  

For many investors, it doesn’t matter how equity markets have performed; it is how their portfolio as a whole has performed that is important.

While equities will certainly be a strong contributor to portfolio performance, the contribution from fixed income, property, cash, and other alternative-style investments cannot be over looked. It is important for all investors to recognise this, especially when experiencing periods of volatility. 

This makes great sense on paper. But the reality is that the ability to adequately assess the risks and returns on offer across multiple asset classes in multiple markets requires skills that most investors simply don’t have.

This is not just because sector-specific investment decisions require a sector specialist, but because allocation decisions between different investment classes and different geographical areas is also a skill in itself. 

Navigating changing market dynamics 

Investment markets change rapidly, and for most individual investors keeping abreast of the dynamics at play is challenging.

For investors to succeed, they must know the right answers to a host of questions – all being asked at the same time.

And this is assuming they know the questions: in reality, investors don’t always know what they don’t know.

Further, they often don’t have access to the information needed or the local knowledge required to make informed decisions about offshore investments.   

For example, low interest rates, wage suppression and a desire by US corporates to pay down debt in the wake of the GFC have contributed to profit margins which are at or near all-time highs. But are these levels sustainable?

Are US equities now overpriced? Should an allocation to US equities within a portfolio be reduced? 

At the same time, on a price-to-book value, do Japanese equities offer real value? And with its Government engaged in significant structural reform, perhaps an allocation to Japanese equities is a good idea? 

Another example is government bonds. Globally, government bonds are generally perceived to be expensive, but, because they are generally negatively correlated with equities, could they – as part of a diversified portfolio – provide a good risk/return trade-off and lower its overall volatility?

If so, what does the ideal allocation to government bonds look like right now? 

Clearly then, orienting a portfolio to sectors and regions in line with changing market dynamics and risks can be a powerful way of increasing returns. But it requires more specialist skills and more time than most investors have.

For investors seeking a portfolio structure that delivers rewards on the upside – combined with protection on the downside – there’s a list of risks as long as your arm: credit risk; securities risk; duration risk; interest risk; equity data risk; and individual security risk, to name just a few. 

What it all boils down to is that when managing a diversified global portfolio, it should be a fund manager’s imperative to direct investors away from harm while simultaneously orienting the portfolio to what they believe to be the areas of the globe with the best risk/return characteristics.

David Redford-Bell is vice president of BlackRock.