One enduring belief in investing is the trade-off between risk and reward. Yet, empirical studies show that taking excessive market risk either has no, or actually, a negative correlation to total investment return. There is even a name for this phenomenon: “the low volatility anomaly.”
For investors, the key questions should be:
- What is the optimal amount of risk I need to take to achieve my desired return?
- Is this amount of risk acceptable to me?
A GIC is one example of a “risk-off” investment; the capital is secure, and the market price does not fluctuate. The trade-off for zero risk is low return. In fact, with interest rates at historical lows, the total return on some low or no-risk investments is negative after taxes and inflation. What, at first, appears to be a safe investment actually contains the real risk of not keeping up with the living costs, particularly in retirement when we must draw from our investments.
On the other hand, having exposure to assets such as equities, whose prices fluctuate more often, is considered “risk-on”. Of course, investors expect to be compensated for taking some risk. Historically, equities have outperformed fixed-income investments.
A well-constructed investment portfolio needs the right asset allocation, always keeping in mind the investor’s risk tolerance and financial goals, as well as market risks and opportunities. Our individual orientation to risk is dynamic, changing along with our circumstances and life stages. Someone who is risk-averse in one area of life (e.g. skydiving) may be quite risk tolerant in another (e.g entrepreneurship). Likewise, at any given time, the market presents us with a dynamic range of risks and opportunities.
A tactically managed portfolio incrementally increases exposure to the market when conditions are favourable and reduces exposure when there are fewer opportunities for growth. The adage, “A rising tide lifts all boats” can be countered with another one, “A falling tide lowers them.” In the midst of bull markets, unhedged exposure to equity markets can generate high returns. (No one complains.) Unfortunately, asset prices can also move in the opposite direction.
An investment strategy that smooths out returns by managing volatility is more likely to outperform a purely risk-on strategy. One reason for this is by hedging risk, it experiences lower drawdowns in down markets. A more even market ride allows investors to remain committed to the long-term investment plan and not sell in falling markets, nor buy at elevated prices. Numerous studies have confirmed a low volatility portfolio performs well under various market conditions, not only during down markets.
Market corrections are inevitable. Those investors who avoid significant losses, including and especially, a permanent loss of capital, are able to build wealth through the power of compounding. Albert Einstein said “compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
This is why it is important to evaluate returns on a risk-adjusted basis which is simply a measure of how much risk was taken to produce the return. One of the most commonly used risk-adjusted return metrics is called the Sharpe Ratio.
A dynamic portfolio is an all-weather investment that performs well in all economic conditions. Under the direction of a tactical manager, who is able to adapt quickly to changing market situations, it delivers solid returns with less dramatic ups-and-downs. This allows investors to sleep-at-night and continue to build wealth to meet their current and future needs.