Is now the time to increase risk?
There’s no such thing as a risk free investment and in fact, risk is an important driver of returns. The higher the potential risk, the higher the potential returns, and vice versa.
But risk should not be defined with a narrow definition of price volatility. Price or valuation risk, crowded positions should all be included in investor’s attitude towards risk. Expensive, crowded markets entail a significant risk.
All SMSF investors need to understand their own appetite for risk and the risk profile of the investments in their portfolio. The first step is working out your own risk profile.
An investor’s risk profile is as a function of age, investment objectives and the ability of the portfolio to sustain short-term losses. If an investor has a short time horizon, losses can impact the overall value of the portfolio more seriously than if the investor has longer to retirement and can ride out short term dips. If the investment horizon extends beyond one, three or five years, it is possible to take on more risk without it negatively impacting the value of the assets in the portfolio over the longer term.
When assessing the risk profile of your portfolio, it’s important to assess price risk based on forward-looking information. When an asset class becomes expensive, it does not matter how it has performed historically in terms of risk profile. What matters is what is happening in the market presently that could affect its value.
For instance, risk is increased when investors buy defensive assets at high valuations, which is what is happening in the market right now. But risk is reduced when an investor takes an interest in a growth asset when it is under-priced. For instance, some investors may form the view that European banks are growth assets that are under-priced at the moment. These businesses have been sold off by investors due to concerns about financial stability in countries such as Spain and Portugal.
But it could be argued that investors are taking an overly pessimistic view of these banks by extrapolating the bad conditions of the past few years well into the future and given there are signs that the economic recovery in Europe is gathering pace, a worthwhile investment opportunity is appearing, Of course, it doesn’t mean investors should allocate heavily to these areas, but it's important to think outside the conventional wisdom box and think, the entire banking sector in Europe is unlikely to go bust and bad news will not last forever.
The idea is to identify markets that are under-priced and look for several of these opportunities across various asset classes and regions, to help manage risk. Conversely, taking a concentrated exposure in a limited number of areas increases risk.
Risk is a function of an SMSF’s investment objectives. As you get closer to retirement investors generally take less risk to help preserve their retirement savings and reduce the chance of a serious market event decimating the value of their portfolio just prior to retirement. But for many investors, it will still be important to take some risk, even after retirement, to help generate portfolio returns.
No matter what your risk profile is, it can be prudent to think counter-intuitively about risk. Sometimes when news is bad it can be an opportune time to increase risk, while when market sentiment is positive it can be a good time to reduce risk.
Current market risks
Risks are often unique to the market cycle. For instance, sometimes variables such as house prices are considered to be a risk, at other times this won’t be the case.
At the moment the market is concerned about the risk of a correction in the bond market after a 30-year bull market. But in a low-growth environment, it may still make sense to hold an allocation to bonds in a portfolio. It’s also worth noting that central banks are one of the main bond buyers, and it would not be in their interests to sell off bonds and cause a substantial decline in the market. But if this does occur in the bond market, it is likely to cause corrections in other markets such as equities.
Rather than a serious correction, what may happen is a rotation by bond investors out of the bond market and into other sectors that do have higher growth potential as global growth picks up, for instance emerging markets.
Risk is one of the most important considerations for SMSF investors. It’s not something that should be considered ‘set and forget’. Rather, it’s essential for investors to continually assess risks in the market as they relate to the assets in the fund, to ensure the value of the portfolio is not unduly exposed to risk. But it is important to do that in reaction to backward looking measures of return and volatility. It's highly critical to form a strong investment philosophy and have a discipline to stick by that philosophy. Constant vigilance when it comes to risk is essential.
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