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Risk
About 35 years ago there was a breakthrough when modern portfolio theory was developed. This basically equates risk with volatility of returns and it is now universally used as a risk definition in financial circles even though it does not make much sense to the average punter.
If returns from say a share market investment swing wildly from one year to the next, it is classed as high risk. If the returns are stable, from a fixed term deposit for example, then the risk is considered to be small. If you are a short term investor then the theory seems to work.
The sharemarket is volatile and can change course dramatically and without warning. Anyone wanting to invest for one or two years would probably be well advised to steer clear.
The practical use of portfolio theory is that you can reduce risk by diversifying your investments - by incorporating in your portfolio different investments that have different patterns of volatility. When one goes down it is offset by an investment that rises. In 1987 for example, the share market crashed but property prices immediately began to rise.
If you mix say Australian shares with international shares, a bit of property and some fixed interest investments, then it is extremely rare that they will all produce a negative return in the same year. True you sacrifice some longer term gains in the process but if people are nervous then diversification seems to be worthwhile.
Almost all financial planners recommend this approach and large superannuation funds are required to do this by law. It also seems to make common sense - it's the eggs and baskets approach. But is it valid?
According to some old timers it is not - particularly if you have a reasonable time frame. If you are intent on building wealth over the longer term then diversification simply reduces your overall return without any reduction in risk. If wealth creation is the goal then short term becomes ten years, medium term becomes 30 years and long term is an entire lifetime.
Take a look at some figures prepared by the Frank Russell Company for MLC Investments. It compares the returns from a number of different investments from 1937 to 1995. It includes shares, government bonds and cash (Treasury notes). Property was excluded because reliable data does not go back far enough.
Capital Market History - Rolling 1 Year Periods 1937-1995
|
Return |
Deviation | |
| Australian Shares | 13.6 | 21.9 |
| Australian Bonds | 6.6 | 9.6 |
| Treasury Notes | 6.0 | 4.4 |
| CPI | 6.0 | 4.3 |
Capital Market History - Rolling 5 Year Periods 1937-1995
|
Return |
Deviation | |
| Australian Shares | 11.9 | 7.8 |
| Australian Bonds | 6.2 | 5.6 |
| Treasury Notes | 6.1 | 4.3 |
| CPI | 6.1 | 3.2 |
If you examine the returns over one year periods, the share market returns 13.6 per cent a year compound while government bonds and cash investments return less than half this. But the price you pay for higher returns is higher risk - as measured by standard deviation. The figures show that shares are more than twice as risky as bonds.
But if you lump the same figures into rolling ten year periods, the whole scenario
changes. Shares still give annual returns more than double the other investments but the risk has reduced dramatically and is now virtually the same.
In other words if you have a ten year horizon (or longer) then shares carry the same risk as everything else but give double the returns. The message from this is that for long term wealth creation forget diversification and go 100 per cent into shares.
Of course trying to convince a financial adviser this is the appropriate way to go may be difficult. Advisers get nervous if their clients lose money in any one year and fear they may lose the business. They tend to focus on short term risk management rather than on long term wealth creation.
So what is risk for longer term investors? It is investing in poor quality assets (that may go bust) and investing in inappropriate assets (ones with low returns).
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