No investor wishes to experience peak-to-trough falls in the value of their investment portfolio of the order of 50%; and certainly no investor wishes to experience such falls twice in a decade.
Chart 1 illustrates the size and frequency of peak-to-trough falls in value that are the stuff of investors’ appalling vistas, namely, large peak-to-trough falls in value followed long periods of time for the value of the investment to recover to its former peak.
Chart 1 : Peak-to-trough falls illustration
The hidden face of risk lurks behind Chart 1. How can risk management help us avoid such large peak-to-trough falls in value and a lost decade of investing? There are at least two means by which an investor might manage the risk of a portfolio to avoid the kind of losses we saw in Chart 1. These are illustrated in Chart 2.
Chart 2 : Managing the risk of a portfolio
Diversification is one approach to risk management.
There is no asset class that always increases in value. If there were, we would all be invested in it. Every asset class has periods of positive returns and periods of negative returns. However, by putting together asset classes with similar expected long-term, risk-adjusted returns that tend not to have their periods of good and bad performance at the same time, we can achieve better risk-adjusted returns. Put more simply, we can get the same return for less risk.
Target a Risk Range
Targeting a risk range is the other approach to risk management we identified above. This alternative approach to risk management involves choosing a level of risk or a risk range with which the investor is comfortable. The trade-off in the choice of risk level is between the risk of loss in a market crisis and the expected return from your portfolio. Once the target risk level or target risk range has been chosen, we can measure and monitor the risk of the portfolio on a regular basis and adjust the constituents of the portfolio to keep the risk in the investor’s chosen range. One popular measure of risk is the standard deviation of return. It’s a measure of how much the expected annual return might vary from one year to the next. Chart 3 illustrates the idea.
Chart 3 : Standard deviation of return illustration
In Chart 3 we can see two different distributions of return around an average value which is taken to be zero for convenience. While both of the distributions of return have the same average value or mean return, the likely range of returns about that mean, is the widest for the orange distribution while it is the narrowest for the purple distribution.
Standard deviation gives us an idea of the size of potential swings around the expected return.
Peak-to-trough Falls in Value
For any given time horizon, the principle factors that influence the size of large peak-to-trough falls in value are:
- Average level of risk of the portfolio; and
- The extent of variation of risk around that average level.
So if we combine our two approaches to risk management we could:
- Diversify a portfolio across a range of asset classes that do not have their periods of positive and negative performance at the same time so as to reduce the risk of the portfolio without sacrificing too much in the way of return; and
- Target a specific risk range, so as to reduce the extent of variation in risk.
The two risk management tools of diversification and target-risk management can significantly reduce the risk of a large peak-to-trough fall in the value of a portfolio.
Magnet and Compass
Friends First uses both diversification and target risk ranges to manage the risk of the Magnet and Compass range of multi-asset funds .
The views and opinions expressed in this article are those of John Caslin, Head of Investment Proposition at Friends First.