I go for a bike ride most Sundays. Wherever I can, I ride on a bike path. Often there is a road running parallel to the bike path. Very often, cyclists are on the road when they could just as easily be on the bike path.
Now I understand why they do this. It’s because you can go faster on the road than on the bike path.
But the thing for me is, you don’t get killed on a bike path. No cars to get under the wheel of.
I know it doesn’t happen often on the road, but cyclist definitely get hit, and occasionally killed by cars.
So why would anyone choose to ride on the road when there is a perfectly good bike track option?
I ask because I often see the same thing with investing. People could use a low risk option and achieve their objectives. Yet they chase higher risk options.
So that’s what we’ll be exploring in today’s post – high risk and low risk investment options, and when it makes sense to use each. Because I suspect that when investing, some people ride on the road, not realising that there’s a perfectly safe bike path only meters away.
A good place to start is the concept of a Risk Budget. This is a term used by professional money managers, and can certainly have an application in investment planning for normal people like us too. Institutional investors have a myriad of analysis tools that allow them to optimise their portfolios for their risk budget, but for the rest of us, it’s enough to just understand the concept and reflect on whether we’re behaving logically in this context.
The idea is that a given investor has a certain amount of risk that they’re prepared to stomach. Most typically in this context risk is referring to the volatility of potential outcomes. So a low risk investment might say produce returns in the +9% to -3% range, while a higher risk investment might have a range of returns between +15% and -%10. So the higher risk option has a broader range of potential outcomes, and therefore greater uncertainty.
Let’s say that given your time frame and general temperament you’re after an investment in that low risk range. One way to approach your investment planning would be to think in terms of having a certain amount of risk that you’re prepared to take on – to spend if you like.
Now one extreme way you could spend your risk budget would be to use a small amount of investment money to buy lottery tickets, and leave the remainder as cash in the bank. Most likely the lottery tickets will prove worthless and so you’ll lose money there, but your bank deposits will earn a small amount of interest, and so in combination your outcome will be within an acceptable range.
Another way you might deploy the same risk budget is to put 30% of your investment amount into international shares, and the remaining 70% in term deposits. Or perhaps you put 20% into a really aggressive investment, perhaps that includes borrowings, and place the other 80% in a bond fund.
The point is, there are all sorts of ways that you could structure your portfolio whilst still retaining the same total amount of risk. This is the concept of a risk budget. You have a certain amount of risk to “spend”, and as an investor, you want to try and find the most efficient way to spend it – get the most bang for your buck I guess.
Generally, a key way investors try to optimise within a given risk budget (even if they’ve never heard of the concept) is to diversify. So in the examples I gave earlier, none of the potential solutions involved a single investment.
Diversification is really important when thinking about risk, because another important consideration when planning an investment portfolio in a risk budget context is that you are trying to find the most efficient use for that level of risk.
So if you’re prepared to take on a certain level of risk, what you don’t want to do is chose an investment option that delivers a lower likely return compared an alternative with the same level of risk.
Let’s say two investments were presented to you. Their range of returns each year was expected to be between +10% and -5%. But one option had an average expected return of 8%, whilst the other had 6%. Same level of risk for each, but one is likely to produce a higher return on average. Which one are you going to choose?
Pretty easy isn’t it – you’ll go for the one with the higher return.
Let’s flip it and consider instead two new investments. Both have an expected 5 year return of 8% per annum. Option A however has an expected range of returns year to year far more diverse than option B. So with option A, your yearly return might be +20%, followed by -12%, followed by +14%. Whereas option B is much more steady as she goes – 7% one year, 8.5% the next, etc.
So each investment has the same average return over a 5 year period, but option A has a more volatile path to get you there. Again, which investment would you choose?
There’s probably a few thrill seekers listening who would say option A, but hopefully most of you would say option B – they should both get the same result in 5 years’ time, but just in case your plans took an unexpected turn and you needed to get your money out in year 3, option B provides a surer bet.
So to summarise, a rational investor is either trying to get the highest return they can for a given level of risk, or, if their goal is to achieve a certain level of return, then do that whilst incurring the lowest amount of risk possible.
So why does someone invest in Bitcoin or one of the other crypto currencies? These are volatile investments, and so should certainly be considered high risk. I have clients with whom I’m working on long term financial plans, and who are on track to meet their objectives. Yet when Bitcoin mania was sweeping the planet a few months back, they were asking me if I thought they should buy some. I even had one lady in her 70’s who only ever invests in term deposits because the share market is too risky, give me a phone call to ask this question.
No question the trusty FOMO reflex is on display here – Fear Of Missing Out. But if your goal is say, to semi-retire at age 50, and we’ve determined that, given your savings rate, employer super contributions etc., you need to earn 7% per year, then why take on a high risk investment like Bitcoin, when you could get to your desired destination with a regular balanced portfolio? Circling back to my bike rider’s observation earlier, why ride on the road, where there’s the chance of getting squashed by a car, when you could ride on a bike path?
So what’s the equivalent of a bike path for Financial Autonomy investors? Well, diversification is really the focal point. You want to diversify across asset classes, currencies, sectors and perhaps investment approaches.
Exchange traded funds and managed funds are a good place to start. Sure, with these investments you won’t get the occasional excitement of an individual share doubling or quadrupling, but nor will you see them drop sharply in value overnight. It’s very much hare and tortoise, with the funds providing the slow and steady outcomes of our hard shelled friend.
You also want to think about your allocation to capital stable investments such as term deposits. If your goals can be achieved by earning say 5%, then there’s no point holding a large portion of your savings in volatile assets. Essentially, why take risk if you don’t need to? So for someone in this situation, perhaps they hold 40 or 50% of their portfolio in term deposits, and the remainder in assets with exposure to long term growth such as shares and property.
I hope you found that useful. If you’re a rider let me know what you chose on a typical outing – road or bike track.
General Advice Warning