During these turbulent economic times, people may be tempted into taking drastic action with their investment portfolio. For example, if a RM100,000 investment is reduced to RM80,000, that may trigger various reactions towards that RM20,000 loss, such as selling all or some portion of the investment, buying more of that investment, or even doing nothing at all.
These possible reactions from different individuals can provide some important insights into risk profiling. With the current volatile market conditions, understanding investment risk and implementing a systematic investment plan would assist investors to meet their long-term financial goals. Investors might typically ask “What are the risks involved in portfolio investment? What is a safe investment portfolio? How much risk should I take?”
1. Volatility, market information and noise traders
Proper research prior to investing is crucial as it’s important to understand the types of risk associated with each investment. However, investors tend to be confused between the concepts of ‘risk’ and ‘volatility’. In financial terminology, risk refers to the probability of losing an investment capital based on the expected return on any particular investment. Meanwhile, volatility measures price fluctuations in a security, portfolio or market segment. Typically, market news, such as changes in the company’s management team or an announcement about share dividend payouts, can result in stock price volatility.
There’s a growing number of information channels now serving the market, to the point that investors aren’t able to monitor every piece of information released. In fact, many investment decisions are influenced by emotions rather than rationality, which makes them difficult to manage. This is because emotional investment reactions cause short-term volatility. For example, positive news usually gives happiness to the investor, while negative news can lead to excessive reactions.
Emotional investments are usually revealed through the distinction between informed and uninformed investors (noise traders) and how they interpret market information. Meanwhile, noise traders refers to investors who trade based on what they falsely believe to be special information or their misinterpretation of useful information regarding the future price or payouts of a risky asset.
One of the factors of noise trading is the need for liquidity. To be specific, investors may liquidate an investment in order to reduce the risk factors. They tend to buy and sell on market reaction. This is an impulsive action based on irrational exuberance or emotions, such as fear or greed, without any major consideration on the long-term returns.
2. Making informed investment decisions
In reality, investors become highly emotional upon experiencing losses to the point of even selling off their investment. Therefore, frequent updates of risk profiling are essential in order to match the investment portfolio with the investor’s risk appetite. By performing risk profiling, investment advisers would be able to identify the investor’s level of required returns and their risk appetite in terms of capacity and tolerance. As a result, their investment objectives could be better achieved.
Risk profiling involves three types of risk measurement: risk capacity, risk required and risk tolerance. Risk capacity is a mathematical measure of the maximum level of risk that the investor could manage before it affects his/her financial goals. Therefore, this should be determined in the early phase of the risk profiling process, and act as a reference for the investment portfolio risk. Furthermore, risk capacity could be used during risk analysis to help determine the choice of appropriate risk responses. Moreover, it would also help manage financial risk shifts in the long term. This is also influenced by the investor’s financial factors, such as promotion or job loss, new-born child, or health issue that could lead to unpredictable medical bills.
While the risk capacity indicates the maximum level of risk that an investor can manage, the risk required refers to the optimal level of risk managed by the investor to achieve the desired level of investment return. Reaching this level is essential to fulfil the investor’s investment objectives and it also shows the direct correlation of the required risk with the investor’s required level of return.
3. Systematic investing
There are two concepts to be considered by investors in systematic investing, namely diversification and dollar-cost averaging. Based on classical finance theory, an investor’s risk-averse traits will determine the proportion of allocation between a number of risky and less risky assets.
Asset allocation refers to a strategy used by individuals to divide their investment portfolio between diverse categories to minimise their investment risks. This strategy is in line with the saying ‘do not put all your eggs in one basket’. Moreover, investors can choose to invest in the money market, fixed income and equity market. The asset allocation in the investment portfolio will reflect the investor’s need for growth, income and liquidity. Therefore, the allocation should cover the investment horizons, risk-free rates and expected returns on risky assets.
The dollar-cost averaging (DCA) strategy implements a regular and periodic purchasing of an investment. DCA gained popularity among financial advisers and individual investors after the recession throughout the mid-1960s. Furthermore, it encourages the investment of the same amount of money rather than the same number of shares each period. As a result, investors can purchase more shares at a lower price compared to when the shares are priced higher.
4. Periodic review
It’s highly recommended that investors should regularly review their investment portfolio to make sure that their investment performance is in line with their expected returns and investment objectives. In the current volatile market, some investments may present good performance at times, while there are times when their performances won’t be as good, and vice versa. If this isn’t done, an investment with poor performance could significantly affect the whole portfolio’s returns, especially if it constitutes a big part of the portfolio.
By reviewing the investment portfolio, investors would be able to separate their emotions and tactical decisions from their pure investment processes. However, the key question is when investors should review their investment. In general, a review of investment portfolios should be done with their financial advisers on a yearly basis, but additional reviews should also be done when investors go through different stages of life.
To illustrate this point, during the early stages of an investor’s career, he or she would usually need a combination of liquidity and growth in their portfolio. Throughout their employment period, their risk and return preferences will reflect that they have stable incomes and they may experience an increase in their commitments and goals. Following that, as they approach retirement, the investment portfolio should primarily reflect their need for income, including several stages of growth to manage the effects of inflation.
Investor anxiety over a decrease in investment value by more than 30% is inevitable. In fact, when the market faces extreme volatility, some investors choose to rely on their instinct to make investment decisions instead of data and trends. While there may be a few extraordinary individuals who may make the right calls, most individuals end up making huge mistakes.
Essentially, risk is a natural component of investment. However, greater knowledge regarding the risks associated with investment and the practice of risk profiling would assist investors in determining their comfort level and building their portfolios and expectations accordingly.
About the author
Joe Tiong, CFP, Investment and Financial Planning Unit at UOB Kay Hian Wealth Advisors Sdn. Bhd. Her expertise is focused on financial planning and wealth management across an investor’s life cycle. She is also responsible for equipping financial advisors with the right skillset and materials in conducting business. She can be contacted at firstname.lastname@example.org
Content retrieved from: https://www.smartinvestor.com.my/how-much-risk-investment-portfolio/.