Asset values fluctuate according to market conditions, whether it is a house, business, painting, jewellery, stocks and others… The big question, is there anything one can do to forecast the future movements? To forecast something that might happen in the future is extremely difficult, if not impossible. One can look at the past and make a professional judgement. However, the past does not guarantee the future! If that is the case, how does one make a judgement or judgements of risk and its potential future return?.
Risk can be divided in two: Systematic (a broad risk that markets can fall as well as rise affecting all markets) and non-systematic (A risk specific to a particular investment relative to the market as a whole) risk.
The amount of risk one can take will depend on a number of factors. Your objective, term, type of investment etc, play a crucial role, however, the main judgement is usually dictated by ones personality. If you are the type of person who might have trouble stomaching a loss, then stocks and similar investments are too much risk. If however, you prefer your money to grow and are happy to take some risk, then it might be suitable. The age-old saying: To accumulate, you have to speculate, is a valid point. And of course, the words accumulate and speculate, can have different meanings to different people. For example, to some, it might mean making or losing only 5 to 20% and to some it might mean gaining or losing up to a 100%.
No one is alike, therefore at Equity & Bond Associates we make sure that we understand our individual clients expectations and tolerance of risk before making any recommendations.
The below graph shows how risk and reward are related:
To be able to get your portfolio in the blue box or close as possible, one can depend purely on luck or apply Principles of Portfolio Construction. The purpose of this principle is to minimise risk and potentially maximise returns according to the individual investors objective, taking in mind the risk/return relation. Risk cannot be completely eliminated, but can be reduced by applying diversification.
Referring to the above graph, an assets investment risk can be measured on their past performance. All major funds with at least a three-year history will have a Standard Volatility figure. Checking the fund volatility is an important factor when coming to make an investment decision. It shows its past performance over a period (usually three years) over its volatility/risk calculated as Standard Deviation. (A statistical measure of the degree to which an individual value tends to vary, how much it moves up or down, from it peers.)
Another important factor is the correlation ratio of various assets within a portfolio. (Correlation is not used as a measure of risk, but to reduce the overall portfolios risk).
For example, there are a number of investments that have produced in excess of 50% returns during 2002. However, the opposite exists as well, where they have fallen. In most cases if one type of investment (market) produces big returns, and the other one does not, it could mean that their assets are negatively correlated or non-correlated.
For example, when the US Dollar value falls, gold usually goes up and vice versa. Therefore, they are usually negatively correlated.
Or, during the Global Financial Crisis / Credit Crisis stock markets fell heavily, where managed future funds and hedge funds performed impressively. And during the 90’s the stock markets the stock markets were extremely bullish and managed futures and hedge funds performed positively at a lower rate. Therefore, we can say that these two assets have little or no correlation. In other words, one asset can go up or down regardless of the other asset movements.
By using Standard Volatility to measure Risk and using Correlation to measure similarity of asset movements, one can produce a balance portfolio to potentially protect it from different unexpected trend moves.
There are many ways of measuring risk, the other known ones are:
- Sharpe Ratio
- Sortino Ratio
- MAR Ratio
*Please note the ratios are based on the past only and do not guarantee the future