Andrew Gawith: Risk understood poorly by those who profit by it

Investors' appetite for risk generally determines what type of investment they favour. Photo / Richard Robinson

Most investors are vaguely familiar with the tradeoff between return and risk. But risk is generally poorly understood by investors, despite it being the dominant factor influencing their returns.

The tradeoff between risk and return is most often illustrated by a straight line sloping upwards from left to right on a graph; that is, as risk rises so do returns.

"Risk" in this sense reflects the volatility or uncertainty of returns. We have ample evidence that people don't like uncertainty, and it stands to reason, therefore, that they require higher returns to make risky investments.

That intuition, coupled with some mathematical trickery, leads to a less obvious result. There should be a single, best portfolio that we expect to dominate all other possible portfolios. Strictly speaking, that best portfolio should be representative of all assets (shares, bonds, property, commodities etc).

Knowing that, investors face one single choice - how much money do they allocate to the best (but risky) portfolio and how much do they hold in a risk-free asset (like cash). Anything other than the best portfolio offers lower returns for the same level of risk.

In practice, most funds operate as though the global sharemarket is a good proxy for asset markets. Their investments are broadly similar to the global market portfolio, and expected performance on those investments is the market return on average (minus fees, of course).

The only meaningful choice offered to investors is risk, which translates into a level of exposure to the market portfolio.

Typically, aggressive growth gets you 100 per cent of the market, growth 80 per cent, balanced 50 per cent, and conservative 10 per cent. But there is wide dispersion within these categories, and the manager normally has some discretion to alter exposure.

So in theory, and in practice, investors' choice of risk is the most significant factor in determining how their investments will behave.

But there's the rub. That task - choice of risk - is not well understood by investors and, in some cases, their advisers. Sure, most investors can answer questions about how risk-loving they are, and how tolerant they are of losses.

However, these are very vague measures and hardly suitable for arriving at the hard number for risk tolerance required to churn out the ideal portfolio. The answers to such questions are also quite sensitive to how the question is framed.

What investors mostly care about is funds available to them at retirement. But few investors know what they should expect for the long-term value of their investments, and the margin of error around that forecast. Nor do they know how that forecast changes as they change their tolerance for risk.

And the problem is not simply that most investors wouldn't have a clue about what range of returns are likely. Even if such forecasts were provided, people are still poorly equipped to judge how they would react.

What impact would it have on your life if your retirement savings were 25 per cent less than planned? What if they were 50 per cent more?

Observing how real investors behave largely confirms the idea that investors misjudge their own risk tolerance. Expected risk and return, especially for an investment of any significant length, change very little from year to year. But investors constantly switch from aggressive to conservative and back in a cycle of greed and fear, based on the previous year's return.

The reason this risk confusion is so important is that historically, the premium for taking on risk has been substantial. Over the past 110 years, the premium for global equities ("aggressive") over global government bonds ("conservative") has been a real 3.7 per cent pa - a huge difference in a compounding context.

Let's assume you invest $10,000 for 20 years. Using the average historical data for the past 110 years, a bond investor would expect a real return of $13,000 in 20 years' time, with actual returns lying somewhere between $5000 (yes, inflation can easily whittle away the real value of a bond portfolio) and $31,000.

An equity investor would expect to have $22,000 after 20 years, with actual returns somewhere between $5000 and $94,000. Remember these figures are only a guide to the future - the past 110 years of data will almost certainly not hold precisely true over the next 20 years.

The advantage of equities over long periods is the basis for the usual prescription for risk: take on more when you're young and become more conservative as you age.

In a recent book, Lifecycle Investing, two American academics extended this argument, suggesting that younger investors should be actively leveraging their equity investments, and that doing so could increase their lifetime returns without additional risk. Oh to be young again!

* Andrew Gawith is a director of Gareth Morgan Investments.