“The two great risks are risking too much but also risking too little. That’s for each person to decide.” —Jimmy Chin, professional climber
“Just taking risks for risk’s sake, that doesn’t do it for me. I’m willing to take risks that I think are worth it.” —Chris Hadfield, astronaut
Imagine you are on the crest of a snow-covered mountain, gazing at expansive vistas of dramatic snowcapped peaks, surrounded by majestic pine and fir trees. You push off on your skis and glide atop perfect powder, gathering speed as you slalom around trees, feeling the wind in your face, your feet undulating with the varying terrain, until you rest at the bottom. You look up at the face you’ve just come down, heart beating fast and adrenaline coursing through your veins! Now, imagine an alternative scenario—careening out of control down the mountain, your skis refusing to disengage, hearing a pop and feeling excruciating pain as your knee gives way, unable to bear weight, the result of torn ligaments. This was my experience six years ago when I tore my ACL and MCL at Whistler. Has this changed my desire to ski? Not a bit. For me, the thrill (reward) of skiing outweighs the potential peril (risk).
Life is full of trade-offs between risk and reward. How we choose to balance them is unique to each one of us. Just as I risked personal injury to experience my reward of skiing, we all take risks to pursue rewards we consider worthwhile.
“Life is full of trade-offs between risk and reward. How we choose to balance them is unique to each one of us.”
At Clifford Swan, we evaluate risk on a daily basis; investments are undoubtedly far from immune to risk. Just as in life, the reward one receives as an investor is generally relative to the risk one takes.
You can see this risk/reward trade-off in the chart below, which shows the long-term growth of stocks, bonds, and Treasury Bills (a proxy for cash) in comparison to inflation (CPI). Reward can be interpreted by the slope of a line, with a steeper line indicating higher reward. How smooth a line is indicates risk—the bumpier a line, the higher the volatility . . . and risk.
Each asset class depicts a particular historical risk/reward profile depending on the steepness and smoothness of its dollar growth journey over time (in this case, 1925–2018). With the understanding that history is not an indicator of future performance, an extremely risk-averse individual can seek to play it safe and invest 100% in a smoother line, such as 30-day Treasury Bills, and likely receive a lower return in the long run for selecting one of the least steep lines. Conversely, if one can tolerate the ups and downs presented by the bumpiest line (stocks), one could invest completely in stocks and generally anticipate receiving a higher return in the long run, as this line is also the steepest line.
How Much Risk Can You Accept?
The catch is, not everyone has the benefit of a long time horizon. For those who need to start withdrawing from their portfolios, there is always the risk of needing to withdraw funds during one of those times when the steep line is experiencing a bumpy downturn. Therefore, prudence would dictate against investing 100% in the steepest, bumpiest line if one’s time horizon is shorter. Each individual will balance risk and reward preferences according to his or her own unique ability to tolerate the risk represented by each of these asset classes; thus, the amount of exposure an investor chooses to take in these asset classes will reflect each investor’s unique risk profile. A few of the factors an investor may consider when deciding how much to invest in each of these asset classes include age/time horizon, economic circumstances, and liquidity needs. Determining an investor’s unique risk profile is important for setting an appropriate asset allocation (the mix of risky assets and cash, a relatively risk-free asset). Keep in mind that an investor’s risk profile may change, as life circumstances, such as illness or job loss, can influence an investor’s appetite for risk.
The critical question to ask is, “Are the rewards you are receiving worth the risks that you are taking?” For instance, one needs to take sufficient risk to grow portfolio assets enough to beat inflation in order to maintain purchasing power in the future. On the other hand, how did one react to the markets in February 2009, right before the market bottomed? One doesn’t want to take so much risk that it results in sleepless nights and anxiety when markets are down. It’s not about taking no risk at all, but rather about taking enough tolerable risk, and ensuring that you are being adequately compensated for the risk taken. Each asset class has its own risks, as reflected by the roller-coaster-like quality of its line (due to the inherent volatility of each asset class). When setting asset allocation, we want to ensure enough risk is taken to match each investor’s unique risk profile—not too little and not too much.
At Clifford Swan, we extend to portfolio construction the concept of ensuring that clients are adequately compensated for the risks taken. Beyond asset classes, the individual securities that we use to build portfolios also have unique risk profiles. We properly assess individual securities’ risks in order to control how much we take in portfolios. We are not trying to avoid or eliminate risk altogether, but determine how to mitigate or minimize it.
We approach stock purchases for portfolios in a disciplined manner, considering criteria such as sustainability of competitive advantage, long-term growth prospects, profitability, management stability, balance sheet leverage, earnings volatility, and price attractiveness. Higher quality stocks help to minimize volatility of returns. Buying with sufficient margins of safety helps maximize growth.
Some of the criteria we consider when purchasing bonds for a portfolio include credit quality, income stability, price attractiveness, and sensitivity to interest rate movements (a source of volatility in credit markets). As an example, buying higher credit quality bonds helps mitigate the risk of default. All of these considerations assist with minimizing risk, while seeking to maximize compensation for the amount of risk taken.
Among some of the characteristics we seek when purchasing mutual funds are management stability, consistency of investment process, downside protection, positive return history and a long-term focus.
“...an investor’s risk profile may change, as life circumstances, such as illness or job loss, can influence an investor’s appetite for risk.”
When putting a portfolio together, one needs to be cognizant of both portfolio diversification (having the right mix of asset classes that have low correlations to each other—refer to our June 2017 article on asset allocation) and time diversification (long-term focus and diversification of returns over time).
Staying the Course
When seeking to initiate a position in a portfolio, one needs to be patient and fight the urge to buy something at too high a price (without a sufficient margin of safety) by caving in to FOMO (fear of missing out). Likewise, one must avoid getting out of a stock at the wrong time, for example because one is impatient with the timing of the stock’s price growth. Or, worse yet, getting out of entire asset classes altogether because one feels that “it’s a bad time” and risking losing out when those asset classes rebound (market timing). The best approach is to set an asset allocation that reflects your current unique investor risk profile, construct a portfolio that is built for the long term, and have the patience to stick it out.
At Clifford Swan, we seek to balance risk and reward in every facet of the investment management process. We are constantly asking ourselves, “Does the reward received outweigh the risk taken?”
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.