Over the next few days, I want to examine what I think is the single biggest challenge facing investors today – how to build a diversified portfolio when every asset seems to be going up in value, in a correlated fashion? I don’t have any easy answers but I do think we need to go back to basics, think about risk and then think about how certain assets (and strategies) might behave in the inevitable downturn.

Today I want to focus on understanding risk – and then also get our collective heads around what I think are some uncomfortable home truths about investing. So, let’s start with that slippery concept of risk. Unlike returns (which can be measured in a relatively simplistic fashion), risk is a fairly slippery customer.  Risk comes in lots of different shapes and guises. Most private investors look at risk in a very simplistic way – they might ask “how much of my initial capital might I lose if I invest in an asset”? Risk in this sense is thus measured by the potential DRAWDOWN i.e loss in value.

Obviously, this blindingly obvious way of measuring risk has been taken to the extreme by academic economists who’ve constructed a whole pantheon of risk metrics that look at returns data (i.e how much in percentage terms an asset has lost in value) in myriad different ways.  That analysis can turn into exotic-sounding terms such as VaR, or value at risk, a statistical term which puts actual numbers on the possible risk levels of an asset.  Many smart investors do use measures like this VaR but in truth investors need to think about risk in a much more ‘holistic sense’. Risk could mean any or all of the following

• Volatility. How much the value of a share, bond or commodity varies on a daily basis? For many, high volatility implies higher potential risk
• Maximum Drawdown. This simply means what’s the potential maximum loss over a period of time that could hit my financial asset. Many stockmarkets can easily lose 20% or even 30% in a year whereas most bonds rarely lose more than 10% in any one year.
• Systematic Risk. This risk measure looks at how an asset might respond to risks within the system i.e how closely correlated the asset is with wider financial assets. If the US economy nose dives, will my asset also crash in value as well?
• Idiosyncratic Risk. If I employ a manager to manage my money, what risk am I taking if they make a bad decision? The best way of controlling this is to use  a passive, index tracking fund where the risk of poor manager decisions is greatly reduced.
• Currency Risk. My investment in a foreign asset might increase in value but the currency it’s denominated in might move in the opposite direction? One way of controlling this is to think about hedging over the currency risk over the short to medium term.
• Credit Risk. If I buy a bond, what’s the chance of the issuer defaulting on the final payment (or the regular interest payments) ?
• Legal Risk. Will the regulators decide to change the rules governing my investment?
• Liquidity Risk. My asset might increase in value but become increasingly difficult to sell i.e it might become more illiquid which could be a risk if I need to access that investment immediately to raise some hard needed cash!
• Leverage Risk. What happens if I borrow too much money and the cost of leverage starts to work against my investment?

Hidden risk: uncomfortable home truths about investing

Now that we’ve opened up the can of worms that is “risk”, let’s explore some very uncomfortable home truths, especially about in investing in equities. Our first home truth is that equities are even more volatile than you imagine – remember that many investors regard volatility as the text book definition of risk!

Analysis by academics has consistently proved one simple truth about investing in equities over the long term – if the past is anything to go by, equities as an asset class outperform everything from cash and commodities through to bonds.  Equities produced an average compound return of anything between 6 and 7% per annum – compound up that real return over the very long term and you could end with a very successful investment portfolio.

How does this past rate of return compare with other, less risky financial assets? The answer lies in a relatively simple concept known as the equity risk premium, which is perhaps better understood as the extra profits (over safe bonds) to be had from investing in risky stuff like equities. According to academics at the London Business School this still looks like it’s about 3 to 3.5% per annum although they also note that “the equity premium is smaller than was once thought”.

On paper the case for investing a large chunk of portfolio money in risky equities looks incredibly compelling until that is you examine the next three charts. They are all the work of SG quantitative analyst Andrew Lapthorne, and each graphic in turn reminds us that equities are very, very volatile.

The first chart examines the 20 year average real (after inflation) returns from holding the S&P 500 (the benchmark US blue chip index) – the grey straight line in the middle shows the average return while the red, jagged lines show actual rolling returns from holding this index.  Over the 90 years of different 20 year rolling periods, just 12 actually produced the ‘average return’ of around 7% per annum – many decades produced returns in the double digits per annum whilst at last five twenty year periods produced returns of close to zero (per annum, on average). This graphic reminds us that equities are incredibly volatile and that that volatility can hugely impact your expected 20 year returns.

But how does that volatility compare with the next best alternative, less risky government bonds?  The next chart looks at the maximum capital loss over a number of 5 year holding periods for both bonds (red, usually at the bottom) and equities (grey, usually on top). In nearly every period, equities produce much higher maximum losses than bonds – there are in fact many 5 year periods where equities can produce a maximum capital loss of 10% or more whereas with bonds such losses are uncommon.

The final graphic from  Andrew Lapthorne at SocGen fleshes out the relative likelehood of big losses from bonds and equities. It breaks down those five year holding periods, and looks at the probability in percentage terms of different capitall losses  since 1950.

According to Lapthorne, this analysis suggests that “ The bond investor could have bought bonds 90% of the months since 1950 and avoided having a 20% drawdown or more, whilst the equity investor could have only invested in 40% of months to avoid such losses. Extreme drawdown of 40% or more, even on a real basis, is almost unheard of in the bond market, but seen 17% of the time in equities. Yes bonds at sub 2% offer miserable returns, but equities will always offer a higher probability of major losses “.

These statistics should not come as a surprise to any investor – the extra reward from holding equities over the long term comes with an obvious price, which is that equities are volatile and can fall very substantially in price during volatile years.

If you are willing to invest over the very long term and accept a window of opportunity that stretches out for 30 years or more, then you should perhaps be willing to embrace that volatility –  if the future is anything like the past, equities could make you a compound return of nearly 7% per annum in real terms over  the next few decades. Such an impressive return probably implies adopting a buy and hold strategy where you sit tight in terms of portfolio allocations and don’t trade in the short term based on market cycles.

For investors with shorter time horizons, a number of alternatives suggest themselves.

1. The first is that if are not willing to suffer losses of more than 10% per annum, you should avoid equities entirely and stick to bonds – but be prepared to suffer in bullish years when equities shoot ahead.
2.  The next alternative is to actually invest in volatility itself and carefully time investments so that they sync up with increases in volatility – in previous articles we’ve touched on the idea of using structured investments to ‘lock in’ spikes in volatility and in next week’s article we’ll look at some novel  portfolio strategies based on this idea of using options to enhance returns
3. The last idea is perhaps the simplest – don’t try to second guess every bullish and bearish swing in sentiment and focus instead on buying quality assets (such as the S&P 500) when they are cheap.