By Anh Thu Tran, MBA
When it comes to investing, many people put return before risk. Few actively assess their holdings’ risk or have a sense of their risk/return profile. Ironically, a better understanding of portfolio risk can help improve investment decision-making and potentially increase returns. Tools, such as Riskalyze, can help investors understand the risk-level they are taking on and, thus, adjust their investments to better align with their tolerance level.
Merriam-Webster dictionary defines risk as: the possibility of loss or injury. When it comes to investing, there are two types of risks: systematic and unsystematic. Systematic risks (“market risk”) are undiversifiable and impact stocks and bonds broadly. Examples of systematic risks include interest rate changes, recessions, and disruptive political or geographic events. It’s largely impossible (or cost-ineffective) to be invested and fully avoid the impact of these factors. Meanwhile, unsystematic risks (“specific risk”) are diversifiable as they are explicit to a certain company or industry. Examples of unsystematic risks include labor issues, weather problems, nationalization of assets. Investors can limit the impact of these risks by diversifying, especially among assets that are inversely correlated. When asset A zigs, asset B zags.
Risk versus Return – Financial Models
Most introductory finance classes cover risk versus return. In theory, the greater the risk, the greater the potential return. Well-known financial models, such as the Capital Asset Pricing Model (CAPM), Modern Portfolio Theory or Sharpe ratio, seek to capture the relationship between these two components. However, the risk/return relationship is complex when theory meets reality and rationality collides with irrationality (e.g., human emotions and biases).
Behavioral finance is an emerging academic field that seeks to explain the impact of human emotions and biases on investment decision-making and, subsequently, returns. Research has exposed a number of investor biases that adversely impact investment decision-making and, ultimately, returns. One such biases is loss aversion (Kahneman and Tversky, 1979). The pain of losing is psychologically twice as powerful as the pleasure of winning. As a result, many investors have a tendency to sell their winners to “lock in some profit” while holding onto their losers with the hope of a turnaround as they don’t want to accept (or realize) their loss.
Availability, or recency bias, leads many investors to overstate the probability of recently observed or experienced events, because the memory is fresher. So, whether it’s a bull market or bear market, investors have a tendency to project that recent trends will continue indefinitely into the future. This results in the tendency to buy high (under the belief that bull market will keep driving stock prices up) and sell low (under the belief that bear market will continue pushing stock prices down). Whether individually or collectively, such investor biases often produce returns that fall short of benchmarks.
Riskalyze – Measuring Risk
How can investors and advisors overcome these powerful biases? There is no silver bullets. However, continued progress in financial technology is arming advisors with tools that help provide a broader understanding of investment risk (and return). Riskalyze is one such software tools. It evaluates the risk characteristics and past performance patterns of individual investments, weighs their risk and return factors, and then assigns an aggregate risk and return scores (the “risk score”). The risk score falls on a 1 – 100 scale. A score of 1 is cash only – low risk / low return. A 100 score, however, is for a small manufacturer in Malaysia – high risk / high return. Most portfolios risk scores fall within the 40 – 80 range as most investors’ risk tolerance falls around the middle of the bell curve. In exhibit 1, the risk score of 63 suggests that the portfolio is growth-oriented, moderately risky, but not particularly aggressive. The risk score gives financial advisors and individual investors a quick and simple metric to gauge the risk level of an individual stock or a portfolio.
Additionally, Riskalyze translates the risk score into a range for the portfolio’s potential gain or loss over a given period of time. In exhibit 1, the portfolio with a risk score of 63 results in a gain/loss range that falls between (-13.2%) and (+22.2%) with 95% probability over any six-month return period. (NOTE: This range takes into account how much the portfolio would fluctuate based on previous market environments.)
It is oft-said that one shouldn’t invest by looking in the rear-view mirror. However, Mark Twain famously noted: While the past doesn’t repeat itself, it does rhyme. So, while Riskalyze can’t provide the exact impact of the next bull / bear market on a portfolio, it does give advisors a better understanding of the risk / return profile of a client’s investments. Based on this information, they can help guide clients toward a portfolio that is more aligned with their risk tolerance level and goals. This, in turn, may help clients reduce decision-making mistakes due to biases or human nature. Ironically, by focusing on managing their risk investors can create investment portfolios that could yield better returns.
Learn more about how Riskalyze works.
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