I chatted to a new client recently. He had been managing his investment portfolio himself before deciding that it was starting to take up too much time, and that he really did not know how to. After taking him through our investment planning process, we came up with a proposed portfolio for him. Before we could implement the restructure, he asked for an historical analysis where he could compare the proposed portfolio to his existing portfolio.

I sent him the graph below with my analysis:

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He was on the phone shortly afterwards. Why should he invest in a portfolio that has underperformed his existing portfolio? Surely it does not make sense to do the restructure? I was expecting some resistance after seeing the analysis. My response to him was simple. The proposed portfolio was designed with his objectives and risk profile in mind. While the existing portfolio had a better historical performance, it had close to double the volatility as the proposed portfolio, and was riskier than his risk profile analysis suggested. He hit back; why does risk matter when I want returns?

This question stopped me in my tracks somewhat. We had had a long discussion about portfolio construction, his risk profile, his objectives, portfolio costs, etc. so I knew that we had discussed this. Did he forget our conversations? Was I not clear enough in the conversation about risk and return? Did I need to revise our investment process?

So, why does risk matter?

Most investors accept that there is a trade-off between risk and return. In order to get a higher return an investor needs to accept higher risk (volatility) in their portfolio. However, many investors, like my new client, did not understand why risk mattered. My first comment to him was that risk was a bit like his appendix; it did not matter until it mattered. According to WebMD some experts believe that the appendix is just a remnant of our evolutionary past. The appendix serves no functional purpose. However, if it ruptures or becomes infected, it can lead to serious pain or even death. Hence the phrase; it doesn’t matter until it matters. Risk is a bit like this.

I reminded the client that one of the reasons he got in touch with me is because he was uneasy at the high volatility in his portfolio over the past three years in particular. He had been invested in the various funds in his portfolio for about 4-5 years. This reason for reaching out to me was the reason that risk matters; portfolios with high levels of risk tend to trigger off destructive investor behaviours. He was about to sell out of his portfolio when a friend (who is a client of mine) suggested he come talk to me. He had already stopped allocating new funds into his portfolio, and was redirecting those funds to a more conservative money market account.

Evidence of investor behaviours can be observed by looking at the unit trust industry statistics that are released on a quarterly basis. Volatile, sector specific funds tend to experience significant outflows AFTER a period of poor performance. Because these are sector specific, high risk funds, losses can be significant within a short period of time. The large outflows are evidence of those poor investor behaviours being triggered. Broad based, multi asset funds tends to experience significantly less dramatic flows.

This client’s existing portfolio was 100% in local equities, while the portfolio I proposed was well diversified. This diversification is what leads to the lower portfolio risk, but not a correspondingly lower return outcome. This leads to the second point; not all risk converts into return. I always try impress on my clients that risk rewards up to a point. Beyond that point it can be destructive. That destruction comes from higher downside experienced by risky portfolios. This was also evident in the client’s portfolio. Between November 2015 and January 2016 the client’s portfolio was down over 15%. From January 2016 to March 2016 the portfolio was up 18%. But From November 2015 to March 2016 the portfolio was up 0.5%. Over the same period the proposed portfolio was up 3.6%. The reason for the outperformance is that in order to recover from a 15% loss the portfolio needed to achieve a return of 17.6% just to make up the loss. Only then could it start delivering positive returns.

The trick is to find that point at which risk becomes destructive. What we do is look at the client’s investment objectives and horizon to get a sense of how much downside risk we can accept in the portfolio. The long term average return from shares on the JSE is around 13% p.a. so if a client is comfortable with a negative return over a 1 year period, then we can accept downside of 10-12%. If the client has a longer investment horizon and is more tolerant of negative returns in his portfolio then we can increase the capacity for downside risk with the aim of a higher return over time. We would not structure portfolios with downside potential of over 25%. Given the time that it would take to recover from such a loss and start making inflation beating, it is possible that the upswing in the market will have run out of steam.

So yes, risk certainly matters when it comes to chasing returns. It matters because it can trigger the wrong investor behaviours, and it matters because too much of it can destroy portfolio return over time.