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The balancing act

July 9, 2020

reading time: 8 minutes

by Tim Cooper, guest author

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To get the best from their portfolio, investors must balance the three key factors of risk, return and liquidity - here’s how to do it.

The ideal goal for an investor looking to grow their money is to achieve the highest return for the lowest risk possible, while keeping assets liquid. But these goals are competing and you cannot maximize them all simultaneously.

A successful investor will balance these three factors according to their situation, outlook and goals. But how should you do it? First, let us define the three factors.

Return is the growth or income you receive – say 5% a year - from an investment in stocks, bonds, or other types of assets.

Risk is most commonly measured by volatility. Price rises and falls are more extreme over time in a volatile asset. This creates more risk of a loss if you had to sell the asset after a fall. Price fluctuations in a lower volatility asset are smaller, so there is less risk of this happening. Many factors affect risk – for example, stocks are generally more volatile than bonds, and emerging markets are usually riskier than developed markets.

Liquidity describes the ease with which you can convert an asset into cash. For example, you can usually sell shares in a large company quickly and easily. But if you own a large property, it could be difficult and time-consuming to sell.

Trade-offs

To maximize the chances of achieving your investment goals, you need to understand the relationship between these three competing factors.

Generally, the more volatile the investment, the higher returns you should expect over the long term to compensate for the increased risk. For example, shares are one of the riskiest assets but they offer the strongest long-term returns.

If you own an illiquid asset, you should seek a higher return and or a lower risk (either directly or by using it to increase portfolio diversification) in return for the risk of not being able to cash in your asset quickly. For example, someone who wants a regular income but does not need to access their capital quickly might use an illiquid property investment in part of their portfolio, knowing that it will contribute relatively high and stable rental yields.

 

The efficient frontier

Efficient frontier theory explains the relationship between risk and return in more detail. The frontier depicts the optimum return for given levels of risks and is represented by a line sloping upwards from left to right, with risk on one axis and return on the other.

Rachel Gerrol

The line is curved because there is a diminishing marginal return to risk, meaning that adding more risk to the portfolio does not gain an equal amount of return. Because each investment and every investor is different, there is no one efficient frontier – it is just a theoretical way to visualize your performance.

Any investments or portfolios that fall below the line consistently are sub-optimal because they are not getting enough return to justify the risk they take. Research has found that the most optimal portfolios – those consistently on or near the line - tend to be more diversified, meaning they contain a more varied mix of assets.

Balancing buckets

To set your strategy, start by working out what level of risk you are prepared to take to achieve your desired returns, and how much liquidity you need.

David Blake, professor of pension economics at Cass Business School in the UK, said the first factor to consider in this balancing act is your time horizon. 

If you are investing for an event that will happen in less than three years, such as paying school fees, that is considered short term and you would need liquid investments with low or even no risk. If you are investing for retirement in 20 years, you can afford to go for more returns by using some illiquid and higher-risk investments.

The bucket approach
The bucket approach

However, people generally have several investment horizons - short, medium and long, said Blake. ‘In that case, they might consider so-called liquidity layering or bucketing,’ he said. ‘This means keeping some liquid assets to meet near-term expenses, and sacrificing some return; and keeping more illiquid, higher-risk assets to emphasize return for more distant horizons.’

You also need to factor in your initial wealth; how much it needs to grow to meet your targets; and other income that might help achieve your goals. 

You also need to assess your risk attitude and risk capacity. Risk attitude is how much risk you as a person can usually tolerate. Risk capacity is what you could afford to lose, in a worst-case scenario, based on your commitments and resources.

So if your risk attitude and capacity is high, and your timeframe long, you can choose high risk, high return investments, and vice versa if you have a short timeframe or lower risk profile.

To use an organized bucket approach, keep separate portfolios with different risk profiles for long, medium and shorter-term targets. In this way, you can gain peace of mind with an investment strategy that helps meet all your goals and horizons in the most efficient way possible.

The right mix of assets

Your overall risk profile defines the asset allocation in your portfolio – that is, the mix of riskier assets such as shares and safer assets such as bonds and cash.

To give some simple examples, a ‘cautious’ investor with a low-risk profile might typically have 20% to 40% shares in their portfolio, with the remainder in bonds and other safer investments; and an ‘adventurous’ one might have 60% to 80% in shares.

Diversifying your assets across company size and geography should also help reduce risk. If you have a long timeframe, you could also include a small amount – say 5% to 15% - of illiquid investments such as bricks and mortar property and infrastructure. As well as adding stable returns, this adds diversification. But be sure to sell out of such assets well before you need the capital back.

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