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Risk and The Future

 

We all know the first rule of finance: to make higher returns, you have to take more risk. So, it should also logically follow that, if I am willing to accept a lower return, I should be able to take less risk. After all, different people have different expectations for returns and most definitely, people also have different tolerances for losses. But how do I make sure my portfolio is really low risk? The model generally used in the financial services industry involves stocks and bonds. The theory is, one can control the risk of a portfolio, by allocating more to one than the other, under the assumption that bonds are lower risk.

 

But is that always the case? What may seem like a low risk investment at one point, can be something very different in other market environments. The fact is, you cannot predict the future, which means you also cannot predict risk. Think of it this way: with bonds yielding 18% (as they did in the eighties) and bonds yielding near zero (as they do now), wouldn’t that significantly alter the risk proposition? Does it hence make sense to apply a fixed ratio (of say 70% bonds and 30% stocks) to choose a low risk profile at all times?

 

I guess the only thing worse would be, trying to time and actively manage the allocations (and please feel free to compare the track records of active versus passive management since the beginning of time). Clearly, what we have to do is look beyond stocks and bonds to diversify our risks much more broadly. There are many choices from real estate to commodities, venture capital, or trading and investment strategies that do all kinds of different things. Consequently, there are also many ways to structure a much more efficient portfolio.

 

The important thing to remember is to make sure the risks one takes on are truly different to one another, and that one doesn’t allocate a disproportionate amount to any one investment. That way, the portfolio is naturally balanced to withstand any shocks to the downside (as the risks are diversified) and we can earn all the risk premiums that are available on the upside. The only other thing you have to do, is make sure that you don’t overpay for the products and services to execute your investment strategy. Good luck with that.

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