“Successful investing is about managing risk, not avoiding it” – Benjamin Graham
THE word risk is used in many ways and is given different definitions depending on the industry and context. However, risk in investment can be defined as a measure of uncertainty in achieving the returns as per the expectations of the investor.
It’s fascinating to know the term risk was developed as a gambling solution, some 200 years ago. Two renowned gamblers, the Franciscan monk Luca Pacioli and the Italian physician Girolamo Cardano from Milan, provided a formal mathematical analysis of the probabilities in dice throwing.
Although risk has become part of humanity as a lifestyle choice very long ago, it took some time to understand the concept of risk in investment. Modern investors were looking for a strategy that give high returns at a relatively low risk.
Although this strategy seems straightforward now, it didn’t exist until the latter half of the 20th century.
In 1952, Harry M Markowitz, an economist often called the father of portfolio theory, left a significant mark on investment. His “Portfolio Selection” published in the Journal of Finance, received the Nobel Laureate in economics sciences and changed the investment industry forever.
There is no such thing as the perfect investment strategy, but Markowitz’s Modern Portfolio Theory (MPT) could maximise the returns by accepting quantifiable amounts of risk. The first simplified theory from Markowitz is that risk and return are directly linked and the greater the return, the greater the potential risk.
The second theory, we can limit the volatility of investment by spreading out risk among different types of investments. Below are some definite lessons we can learn from MPT as an individual investor:
Risk and return
The primary goal of investing is to grow your money as much as possible.
Regardless of whether we are planning for retirement or saving for a down payment on a new home, our child’s education fund, or something else, investing can potentially help reach your financial goals sooner than simply saving your money.
Unfortunately, every investment carries risk, so you need to think carefully about your investment strategy and understand the relationship between risk and return. Higher risk is associated with greater probability of higher return and lower risk with a greater probability of smaller return.
This trade off which an investor faces between risk and return while considering investment decisions, is called the risk return trade off.
Diversification
Diversification is a technique that reduces risk by allocating investments among various financial instruments. Diversification depends more on how the assets perform relative to one another than on the number of assets you own.
The “right” kind of diversification requires you to own assets that don’t behave alike. The primary means of accomplishing this is through asset allocation, the practice of dividing investment into different classes of assets such as stocks, bonds, real estate and cash that will act independently of each other.
Some of the benefits of diversification, minimizes the risk of loss to your overall investment and reduces volatility.
Understand your risk profile
Before you consider investing in any ?nancial instrument, you must know how much risk you’re ready to take. Risk profiling is important in determining a proper investment and asset allocation for a portfolio.
Every single person has a different risk profile as the risk appetite depends on psychological factors, loss bearing capacity, investor’s age, income and expenses. Your risk profile may change over time, depending on changes in your life cycle.
It could also be due to your income changes or you may have new goals. Hence, what was right and worked for you at a younger age may not be the same when you turn age 60, but knowing your current risk profile is very important.
Remember, the greater the promised investment returns, the higher the risk.
Investment is not gambling
Some people see investing as gambling, but it is not the same as gambling at a casino. In fact, real investors will tell you that there is no gamble involved in investment.
Investing gives you ownership of an asset with potential to increase in value over time. In most cases, this asset will provide some sort of income while you wait. This could be in the form of stock dividends, bond interest, or even rental income.
As an investor, one of the best things you can do for yourself is to understand your risk appetite, provide sufficient time and set aside an emergency fund.
Almost seven decades after his invention of Modern Portfolio Theory (MPT), Harry Markowitz’s theory is still going strong. Harry Markowitz says the greatest lesson investors can take away from any market situation is understanding risk and the importance of diversifying.
While we as investors acknowledge the importance of risk, diversification and asset allocation, it is easier said than done, due to challenges like choosing the right investment instruments among the numerous options and the influence of emotions during the ups and downs of the market. So, it is important for an investor to choose the right asset classes and achieve his investment objectives.
Gunaseelan Kannan, CFP, a Financial Adviser Representative by Bank Negara Malaysia and a Licensed Financial Planner by Securities Commission (CMSRL/B4198/2013), is currently pursuing his Doctorate research on entrepreneurship, financial planning and financial technology. He also lectures on accounting, finance and business fields in Asia Pacific University of Technology and Innovation (APU). He is the Winner of Malaysian Financial Planner of the Year 2020, from Financial Planning Association of Malaysia. He can be reached at [email protected].