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Using risk and volatility to power your SMSF

Risk is the potential for an investment’s return to differ from its expected return. All investments carry some risk their value will fall. At the same time, there’s always the potential for the return to be higher than expected.

Risk and volatility are interlinked and essential forces in financial markets. It’s easy to assume these concepts have negative ramifications, but that’s not necessarily the case.

It’s important for self-managed super fund (SMSF) investors to appreciate how risk and liquidity work in financial markets. The idea is to form views about how the portfolio will respond when risk and volatility change as markets move. 

But first, some definitions. The Australian Securities Exchange (ASX) defines volatility as: “a measure of how wild or quiet the market is relative to its history. It can be more accurately defined as the standard deviation of a series of price changes measured at regular intervals.”

Risk is the potential for an investment’s return to differ from its expected return. All investments carry some risk their value will fall. At the same time, there’s always the potential for the return to be higher than expected. 

Damian Liddell, a financial adviser with Browell’s Financial Solutions says assessing how much volatility and risk an SMSF should take on comes down to two things. 

“SMSF investors need to think about their own risk tolerance, that is how much volatility they are willing to accept. This will be affected by a whole host of things, including their investment knowledge and experience. The second consideration is how much risk they need to take on to achieve their objectives,” he says.

This process involves SMSF trustees identifying investment objectives and running projections to see if the objectives can be achieved. From there, the required level of investment risk can be identified.  

“In some instances, investors may be fortunate enough to be on track to achieve their objectives and they can reduce risk or reassess their objectives. In other instances, some people need to either increase their exposure to risk assets or alter their objectives, for instance by reducing their income requirements in retirement or delaying their retirement date,” Liddell adds.
  
Going through this process provides the investor with purpose. Then, when volatility rises, an informed and purposeful investor is less likely to panic and stray from their long-term plan.

Says Liddell: “It’s important to remember volatility can create opportunities. During periods of heightened volatility people tend to panic and this then leads to them indiscriminately selling things, including quality assets. So for those investors who can keep a cool head and keep things in perspective, volatility can provide a chance to scoop up some real bargains.”

As such, volatility should not be seen as something of which to be fearful. It all comes down to mentally accepting volatility and preparing for it ahead of time.

“Two things drive share market returns: fundamentals over the long term and sentiment over the short term. Sentiment can turn on a dime and when it does it doesn't suddenly mean a quality company's intrinsic value is worth any less,” says Liddell. 

“It's also worth understanding shares are so volatile because they're so liquid and liquidity provides flexibility. Property, on the other hand, is much less volatile because it's illiquid,” he adds.  

Darren Beesley, senior portfolio manager, AMP Capital, agrees it’s important to have a defined level of risk the fund is targeting.

“Without a target level of risk, human nature and behavioural biases kick in and you tend to extend your risk exposure when you've had strong returns, just at the time when you probably should be cutting risk, and vice versa. Not having a risk budget works against you in terms of allowing animal spirits to drive you in the wrong direction in markets,” he adds.

Historically, in an investment fund risk has been expressed as the balance between assets that have growth and defensive properties in a fund. So a balanced fund is typically weighted 70 per cent to growth assets and 30 per cent to defensive assets.

“We don't believe that split is a particularly good measure of risk. Particularly when taking into account alternatives investments, which are not framed as either defensive or growth. They sit somewhere in between, and that blurs the line,” Beesley explains. 

Investment funds’ product disclosure statements typically define risk as how often an investor can expect to experience a negative return. While this is useful, it doesn't relate to how an investor thinks about risk. 

“It doesn’t define how big the negative return is and what it means for the investor and how it could affect their ability to meet their investment goals,” he adds. 

When it comes to volatility, how much the fund can take on is a factor of a number of variables. These include the time horizon of the investment, risk profile and the overall investment goal. 

Volatility isn’t of itself negative. This is the case if asset values tend to go up and down, but generally trend up. If an asset has good fundamentals, volatility can be smoothed out over the long term by good returns. The exception is a severe correction such as the financial crisis of 2007/2008, which can damage asset values to the extent investors have to re-think investment objectives.

The message for SMSF investors is to use risk and volatility to your advantage. For the most part, short-term volatility should not change your long-term investment strategy.    
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