Risk is a natural part of life. Sometimes it’s good, like winning the lottery, and sometimes it's bad, like losing a job.
While we all have an innate understanding of risk, it is often hidden when things are going well, and innate behavioural biases mean we struggle to manage it effectively when circumstances take a turn for the worse.
The long bull market that followed the GFC placed the spotlight on returns but the coronavirus-driven bear market of early 2020 has highlighted the price of underestimating risk.
The ASX 2017 Investor Survey found that nearly 70% of all Australian investors want stable, reliable or guaranteed returns from their investments (see Figure 1). Yet 21% of the most risk averse investors still expected double-digit returns.
Figure 1: Australian investors' attitude to risk (proportion of investors)
Source: ASX 2017 Investor Survey
Advisers have the unenviable task of educating investors about balancing risk and return, and then guiding them through challenging market conditions.
There is no silver bullet to managing risk, but investors typically take three possible approaches.
1. Completely avoid risk
Market downturns are painful. Losing money, even on paper, can cause fear and stress. It is no surprise then that some investors – particularly those who have been burned in a previous downturn – choose to completely avoid risk.
The average person feels the pain from a loss twice as much as the pleasure they feel from a financial gain, according to a 2007 study by AARP and the American Council of Life Insurers. The study found retirees were even more loss averse.
Unfortunately, the downside to this approach is many investors won't experience strong – or even adequate – returns either.
The Reserve Bank of Australia has cut official interest rates to 0.25% in the face of the coronavirus pandemic and suggested it is unlikely to be raised for years. The price of safety may be too much for many Australian investors or retirees, who have some of the longest lifespans in the world.
2. Diversify your investments
Diversification offers many benefits – so many that it is sometimes referred to as the only free lunch in investing1. If it's true, then the free lunch does not always prove nourishing during a severe crisis.
Diversification can't protect investors against systematic risks, such as a global recession, when all major asset classes tend to fall together. Many investors witnessed this during the GFC, when their diversified or balanced portfolios posted heavy and unexpected losses.
In some cases, diversifying portfolios doesn't lower risk because the same risk factors (such as economic growth, valuations, inflation, liquidity, credit and government policy) are driving each asset classes’ investment returns.
Diversification is best viewed as one type of risk management tool, not a comprehensive risk management solution.
3. Actively manage risk
Risk can be specifically managed using a hedging strategy that provides an additional layer of security. It is a common approach among large companies that hedge multiple risks such as currency, interest rates and investment liabilities.
It is also a core component of the Milliman SmartShield Series.
SmartShield's risk management approach allows investors to maintain their exposure to higher potential returns from traditional 'growth' assets while smoothing out volatility and providing a cushion against severe market downturns.
Advisers and their clients, remain in full control and can turn the risk overlay on or off without incurring capital gains tax as the position of clients or markets change.
SmartShield gives investors the confidence to invest for growth while maintaining solid protection against risk.
You can find more information about the Milliman SmartShield range at https://advice.milliman.com/en/smartshield.
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1A quote attributed to Nobel Prize laureate Harry Markowitz.