Wed | Jun 23, 2021

The inherent risks in risk avoidance

Published:Sunday | April 8, 2012 | 12:00 AM

Simone Hudson-Bernard, Guest Columnist

Local investors have often approached investing with caution.This is reflected in the fact that they try to avoid risk, by weighting their portfolios more heavily toward investments where the potential for changes in the value of their principal of their asset is low and uncertainty of returns would not be an issue if the markets become more volatile.

As such, investors have often gravitated towards products such as repurchase agreements or repos, BOJ Certificates of Deposit and short-dated Government of Jamaica bonds.

Even investors, whose personal circumstances and investment horizon indicate that they could assume greater risk, continue to be overweight in these instruments — that is, employ safe haven strategies.

Admittedly, this worked well in the high-interest rate environment as attractive returns could have been earned by taking very little risk.

However, significantly lower interest rates have exposed the risks associated with the safe-haven strategy and highlight the need for a reassessment of local investors' risk tolerance.

The issue of risk tolerance encapsulates two important issues: the investor's willingness to take risk; and ability to assume risk.

The ideal situation is for convergence of the two. However, there is often a mismatch.

Investors who have the capacity to take more risk, based on factors such as young age, wealth and alternate sources of income, may be unwilling to do so.

Sometimes the opposite may also be the case, where many assume more risk than their age, and personal circumstances dictate.

The ill effects of excessive risk taking relative to one's ability are oft discussed and most investors can readily understand and appreciate the adverse effects that can arise from this. However, what is often not explored are the risks involved in the other extreme, that is, taking too little risk.

Ironically, risk avoidance is inherently risky. The most significant risks associated with this strategy include failure to realise the required real returns, failure in meeting long-term investments objectives, and reinvestment risk.

RISK TO YOUR RETURNS

The relationship between risk and return is a fundamental relationship in finance.

Return is the expected reward for assuming risk. The risk-return relationship is positive meaning greater degrees of risk are compensated for with greater expected return on investment and vice versa.

'Safe' assets such as repos, treasury bills and BOJ CDs, usually carry lower risk relative to other form of investments because the principal is returned at the end of the investment period and there is certainty as to the amount of interest to be earned.

According to the risk-return relationship however, a portfolio that has a heavy concentration in safe assets will ultimately result in lower returns. In the high interest rate environment that prevailed until recently, investors were able to earn attractive interest rates on short-term safe assets without assuming significant risk.

However, in the current environment, where rates have fallen precipitously to single digits investors in some instances are at risk of earning negative real returns given that expected inflation exceeds current pre-tax returns on these fixed income assets.

For example, if you are earning 6.5 per cent per annum before taxes on your BOJ CD and inflation is expected to be 8.3 per cent for the year — if the medium term target for the FY2012/13 is used as a proxy for expected inflation — then your real returns equate to negative 1.8 per cent.

This means that the return on your investment is insufficient to offset the impact that the general increase in prices in the economy would have on your purchasing power.

When one considers withholding tax of 25 per cent applied to most fixed income investments, on an after tax basis, investors are even worse off with real after-tax return of negative 3.4 per cent.

RISK TO LONG-TERM GOALS

Individuals often invest with a few short to medium term goals in mind but more often investments are made with the view of achieving certain long-term objectives.

Long-term goals may differ among individual investors. These include the need to finance their children's college education or invest for retirement.

The common thread however, is that these goals are usually significant in terms of the amount of funds required to achieve them.

Usually, there is a strong reliance on the returns from investment and the effects of compounding of these returns to assist in achieving these goals.

Based on the relationship discussed earlier, returns from risk free assets are likely to be insufficient, particularly if inflation is taken into account.

As such, investors run the risk that they will fail to achieve their investment goals as their portfolio did not generate sufficient returns to meet their investment objectives.

Investors would have had a better chance of achieving those goals by adding riskier assets such as
stocks to their portfolio.

REINVESTMENT
RISK

Another aspect of the safe-haven strategy
observed among local investors is the strong preference for shorter term
investments.

As a result investors tend to hold more
short-dated instruments than is necessary to satisfy liquidity needs, in
an attempt to avoid the uncertainty associated with longer
tenures.

This strategy however, exposes investors to
significant reinvestment risk particularly in a declining interest rate
environment, as their investments are rolled over at lower rates on
maturity.

Longer tenure investments would have allowed
them to lock in higher interest rates for a longer time, thereby
increasing portfolio returns.

Investors can readily
appreciate that assuming too much risk is undesirable. However, too
little risk can also be detrimental.

By trying to
eliminate risk, investors misalign their portfolios with their long-term
financial goals and as a result may expose themselves to the risk that
their investment returns will fall short of their future
needs.

The challenge for investors is finding the
right balance between investment expectations and an appropriate level
of risk that is, aligning portfolios with return
objectives.

Diversification is the optimal solution to
this problem. The process involves the combination of more than one
asset from different asset classes and investment tenures, in a bid to
increase returns while reducing the overall risk of your
portfolio.

A diversified portfolio that is rebalanced
based on the economic outlook and changes in personal circumstances is
more likely to yield desired results relative to one that remains skewed
towards one or the other extreme.

Simone
Hudson-Bernard is a portfolio analyst at NCB Capital
Markets.business@gleanerjm.com