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Smart Investing
How to pass the portfolio sleep test
8 June 2007
Robin Bowerman
Worry is a constant companion for some investors.
At a time when our economy’s growth is accelerating – the March quarter’s result boosted annual growth to 3.8% which is the highest for three years – you could understand investors basking in the reflected glory of strong returns. But for some investors the idea that our sharemarket is nudging record high levels is a worry. Success, it seems, brings its own concerns.
And investors are probably right to be concerned – the challenge is to try quantify the risks and have an investment strategy that can withstand future, unexpected shocks.
Typically investors focus on performance and measures their returns accordingly. But how many investors measure and understand the risk in their portfolio? It is the balance between risk and return that is the better gauge of a portfolio’s ability to withstand future shocks.
It is interesting to look back over the past 10 years at the volatility – a measure used by professional investors to quantify risk – of various markets. Just as past performance is no predictor of future returns neither are risk measures but the difference in the volatility across a range of investment asset classes in the first five years compared to last five years ending in march this year provides an interesting contrast.
Across Australian shares, listed property, international shares and even emerging markets the fall in annualised volatility in the past five years has been nothing less than dramatic.
For Australian shares the decline in volatility – measured as the fall in the standard deviation of monthly returns – was almost 30% for the five years ended in March compared to the previous five year period. For emerging markets it was even higher at 35%.
For investors that means the past five years really do qualify as golden years – strong returns coupled with lower levels of risk. Investment theory says that when you invest in asset classes like Australian or international shares you should expect higher volatility or movement in prices than in less volatile asset classes like fixed interest.
So returns have been higher and risks lower across the major growth asset classes for the past five years. History – whether it is measuring return or the risk – does not claim to predict the future but it can provide cautionary reminders about building portfolios that are dramatically out of step with historical norms.
So it was mildly alarming at a recent conference to hear some financial advisers describing fixed interest being “dead” as an asset class.
Expect a Lazurus-like recovery of fixed interest in portfolios if that unexpected shock to global stock markets happens along.
Having a good understanding of the risk in your portfolio may well be the best way to pas the most important investment test of all – the worry-free sleep test.
Whatever your views, you can discuss this article - or any of Robin's articles - on our message board Your 2 Cents.
Robin Bowerman is Head of Retail at index fund manager Vanguard Investments Australia and the former managing editor of Shares and Personal Investor magazines. To receive this column by email each week go to http://www.vanguard.com.au/ and register with smart investing.
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