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“RISK
vs. REWARD”
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, hence at Equity &
Bond Associates, we make sure that we understand
our individual clients expectations and tolerance
of risk before making 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, in the past three years stock markets have
fallen, but managed future funds and hedge fund
have performed impressively. And during the
90’s 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
.
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