Time, risk and returns
Charles Booth, chief investment officer and portfolio manager at Truffle Asset Managers.
Investing is all about deploying capital now to meet a financial objective sometime in the future. Risk is the probability of not meeting that objective. Practically, the risk distribution is not symmetrical, as it is more about downside than upside.
However, conventionally, risk has been regarded as the volatility of expected returns measured over a relatively short period, typically one year. This, in Truffle’s view, is at best a poor measure of risk and, at worst, a grossly misleading figure. For example, over the long term, equities have generally outperformed other asset classes and also outperformed inflation. A long-term investor should therefore always have a very high exposure to equities. But conventional risk measures indicate that equities are a risky investment, implying caution as equity return volatility measured over discrete years has no doubt been more volatile than other competing asset classes.
Spread over a 20 to 30 years, it matters little that equity prices rose or fell by large percentages in any one year. What matters is that at the end of the period, the capital value of the investment has appreciated at least in line with expectations or preferably exceeded expectations. In fact, history reveals that 30-year equity returns are very narrowly distributed, providing investors with high confidence levels over long time periods.
Cash, on the other hand, particularly if tax is taken into account, has generally not provided investors with real returns, except over short periods of time, even though volatility has been very low. A rational investor should therefore conclude that, over long-term horizons, equities are less risky than cash because the investor has a greater probability of earning real returns from equities. Most investors acknowledge this as equity exposures in, for example, retirement funds are on average high.
As time horizons shrink the concept of risk should change, at least for rational investors. Over say a five-year period, while the one-year volatilities for equities do not change, the five-year volatility is materially higher than the 30-year volatility. This means that if risk is about downside, the probability of not meeting investment objectives starts to increase rapidly as time horizons shrink. Cash, on the other hand, while not always providing a real return, does provide capital safety over all time periods.
What does this mean for investors?
Over the long term, volatilities of cash and equities are low. Therefore investors should put a very high weight on the return. This means that equities should be favoured by long-term investors and this rationality is seen in retirement funds, but on average exposures to equities could be higher (except if tactical decisions are made). Volatilities of the other assets classes, such as bonds and property for example, fall in-between cash and equities and similar logic applies. A growing retirement fund should logically have maximum exposure to equities and property, provided valuations are supportive, but this is rarely the case. Using conventional risk measures, it is difficult to concede that this equity-and-property-rich portfolio is in fact less risky than a more balanced portfolio, but, for the long-term investor, this is the case.
However, for a portfolio with outflows and short-term liabilities, it cannot afford to be exposed to the higher volatility of equities and needs to be invested in less volatile investments. Unfortunately, this portfolio should also expect a lower return on average.
It follows from the above that risk is integrally linked to investment time horizons and is not the same for all investors. Investors need to change their view of risk depending on the investment horizon.
