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.
Disclaimers
This document has been prepared by Milliman Pty Ltd ABN 51 093 828 418 AFSL 340679 (Milliman AU) for provision to Australian financial services (AFS) licensees and their representatives, and for other persons who are wholesale clients under section 761G of the Corporations Act.
To the extent that this document may contain financial product advice, it is general advice only as it does not take into account the objectives, financial situation or needs of any particular person. Further, any such general advice does not relate to any particular financial product and is not intended to influence any person in making a decision in relation to a particular financial product. No remuneration (including a commission) or other benefit is received by Milliman AU or its associates in relation to any advice in this document apart from that which it would receive without giving such advice. No recommendation, opinion, offer, solicitation or advertisement to buy or sell any financial products or acquire any services of the type referred to or to adopt any particular investment strategy is made in this document to any person.
The information in relation to the types of financial products or services referred to in this document reflects the opinions of Milliman AU at the time the information is prepared and may not be representative of the views of Milliman, Inc., Milliman Financial Risk Management LLC, or any other company in the Milliman group (Milliman group). If AFS licensees or their representatives give any advice to their clients based on the information in this document they must take full responsibility for that advice having satisfied themselves as to the accuracy of the information and opinions expressed and must not expressly or impliedly attribute the advice or any part of it to Milliman AU or any other company in the Milliman group. Further, any person making an investment decision taking into account the information in this document must satisfy themselves as to the accuracy of the information and opinions expressed. Many of the types of products and services described or referred to in this document involve significant risks and may not be suitable for all investors. No advice in relation to products or services of the type referred to should be given or any decision made or transaction entered into based on the information in this document. Any disclosure document for particular financial products should be obtained from the provider of those products and read and all relevant risks must be fully understood and an independent determination made, after obtaining any required professional advice, that such financial products, services or transactions are appropriate having regard to the investor's objectives, financial situation or needs.
All investment involves risks. Any discussion of risks contained in this document with respect to any type of product or service should not be considered to be a disclosure of all risks or a complete discussion of the risks involved. Investing in foreign securities is subject to greater risks including: currency fluctuation, economic conditions, and different governmental and accounting standards. There are also risks associated with futures contracts. Futures contract positions may not provide an effective hedge because changes in futures contract prices may not track those of the securities they are intended to hedge. Futures create leverage, which can magnify the potential for gain or loss and, therefore, amplify the effects of market, which can significantly impact performance. There are also risks associated with investing in fixed income securities, including interest rate risk, and credit risk.
An investment in an underlying portfolio, whether with or without Milliman Managed Risk Strategy (MMRS) is subject to market and other risks and no guarantee or assurance is given by Milliman AU or any company in the Milliman group that the use of MMRS in connection with an underlying portfolio will not give rise to losses or that the performance of the MMRS in relation to the underlying portfolio will remove volatility completely or to the extent depicted in an illustration or fully replace losses in the underlying portfolio or to the extent depicted. While generally assets used in connection with the MMRS are liquid, this may not be the case in all circumstances. Further, during periods of sustained market growth, the return to clients from the combination of an underlying portfolio and MMRS should be less than if a client had no MMRS.
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Past performance information provided in this document is not indicative of future results and the illustrations are not intended to project or predict future investment returns.
Any index performance information is for illustrative purposes only, does not represent the performance of any actual investment or portfolio. It is not possible to invest directly in an index.
Any hypothetical, back tested data illustrated herein is for illustrative purposes only, and is not representative of any investment or product.
Results based on simulated or hypothetical performance results have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under-or over-compensated for the impact, if any, of certain market factors such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown.
For any hypothetical simulations illustrated, Milliman AU does not manage, control or influence the investment decisions in the underlying portfolio. The underlying portfolio in hypothetical simulations use historically reported returns of widely known indices. In certain cases where live index history is unavailable, the index methodology provided by the index may be used to extend return history. To the extent the index providers have included fees and expenses in their returns, this information will be reflected in the hypothetical performance.
1A quote attributed to Nobel Prize laureate Harry Markowitz.