Risk, returns and diversification.

By Abi Tyas Tunggal 4 March 2018 4 min read

Outline:

  • Avoid locking in losses by understanding your risk tolerance;
  • Your gut will give you a fair insight;
  • Diversifying your investments gives you a level of protection.

When we talk about risk in investment, we are talking about what we are financially exposed to, both positively and negatively.

It’s the amount of money you stand to gain (or lose).

Conventional wisdom states that there is a relationship between risk and return.

The idea is the more risk you are willing to take on, usually in the form of volatility, the greater your expected return will be (and vis-a-vis).

Volatility is how much the price changes of something over a period of time. If the price is stable, there is low volatility. If it moves around a lot, that's a high volatility.

When we take about investors taking on more risk, they are generally demanding a premium (more money)for taking on the additional volatility.

If chances are higher the investment will fail, then the investor wants to get paid more for still making that bet.

Howard Marks, founder of Oaktree Capital, thinks investors aren’t worried about volatility in and of itself but volatility that leads to permanent loss.

As he wrote in Risk Revisited, “we can ride out volatility, but we never get a chance to undo a permanent loss”.

Volatility can freak people out and prompt them to sell their positions, even if that's at the bottom of the business cycle, or there is still longer-term upside in the share.

Permanent loss is a share price goes down because of deteriorating business operations and stays down for a very long time or even forever. You've also permanently lost money when you lock in a sell order for less than you paid.

In order not to put yourself in a position where you're freaked out or you feel unnecessary pressure to sell, it’s important for you to develop and understand your own risk tolerance.

If you don’t know how much volatility you are willing to endure, how will you know how to invest?

How will you react in a downturn when your portfolio loses 10%?

If you sell every time your portfolio goes down by 10%, you’re locking in permanent losses.

Differing risk tolerance

The best way to understand risk tolerance is through examples.

Let’s imagine you and your friend both have $10,000 to invest. You want to invest your $10,000 in the IPO of a technology company. And your friend wants to invest in a diversified portfolio primarily built by ETFs.

Your portfolio’s performance is based on one stock, whereas your friend's is likely based on hundreds, if not thousands, of companies.

If your one company fails, you could lost everything. If one of your friend's companies fails, it will be mixed in with the results of all the others.

But if your one company succeeds, you could see your investment return plenty of times more than what you put in. If one of your friend's companies succeeds, it will be diluted by the results of all the others.

If you're comfortable with the one company bet, you have far more risk tolerance than your friend.

For you to suffer a permanent loss, only one company has to go out of business.

For your friend, that number is a lot higher. They likely have exposure to multiple sectors and geographies.

By reducing the reliance on a singular company, sector, asset class or geography, your friend is reducing the risk of permanent loss and often volatility. (Depending on the correlation between the investments.)

Risk reward chart

Diversification

Diversification is about spreading your money across different, loosely or negatively correlated asset classes and geographies.

The goal is to leave you less exposed to a single economic event like a downturn in a singular sector or the collapose of one company.

By investing across asset classes, you can reduce the overall volatility in your investment portfolio. If you have a mix of shares, bonds, cash real estate or gold and other commodities, you can lessen the impact if one category might fail.

That said, diversification does not guarantee returns nor protect you against losses.

Mathematically, diversification is minimising the variations in your returns by averaging the expected return of each of your investments.

Imagine you have $10,000 and you invest $2,500 in four different investments.

Stock A has a return of negative 50%, stock B has a return of 10%, stock C returns 5% and Stock D moves in the opposite direction to Stock A, so it goes up 50%.

Your return would be an average of each of these returns, so your return would be 3.75% because (-50 + 10 + 5 + 50)/4 = 3.75.

Summary

Depending on your risk tolerance, you may choose to be more or less diversified than the average investor. What is important is you understand your own risk tolerance.

If you don’t, you may overreact and lock in losses by selling investments that are volatile.

It’s impossible for us to predict the future. We can only build a portfolio that reflects our risk tolerance and investment beliefs. For most of us, we want the best returns with the lowest amount of risk. That’s hard.

“In order to achieve superior results, an investor must be able to — with some regularity — to find asymmetries: instances when the upside potential exceeds the downside risk. That’s what successful investing is all about.”

Howard Marks, founder of Oaktree Capital.

Risk, returns and diversification.