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01 Aug 2012

Are You Addicted To Risk Aversion?

The investment management industry, and indeed the average investor, is preoccupied with short-term performance. Funds are ranked by performance, judged monthly or quarterly, and awards are based on performance over relatively short time horizons. Assets often flow from funds that have underperformed over the short term to those that have outperformed over the same measurement period.

According to Mike Soekoe of Foord Asset Management, there is also compelling evidence that investors chasing returns often do so to their prejudice by switching to riskier asset classes when these are fully priced or expensive, and by switching from such asset classes when they are cheap or offer value. 
 
“It has been observed that equity funds experience net inflows near the end of bull markets (and money market funds experience concomitantoutflows). Money market funds experience inflows at the bottom of bear markets, precisely when the opportunity to invest in the riskier asset class is mostfavourable.”
 
“Perversely, it would appear that investors might perceive less risk in an asset that has moved up, and more risk in an asset that has declined in price. These observations are not just examples of bad timing,” says Soekoe, “to us, they demonstrate that investors don’t properly understand the concept of investment risk.”
 
“Too few investors perceive risk as the chance that invested capital will be lost permanently. Too many investors see risk in the short-term volatility or variability of returns – measured in days, weeks and months.  It is this disconnect which results in behaviour that we classify as an addiction to risk aversion.”
 
Because it is difficult to value a company, share prices tend to be especially volatile. This is particularly true in times of economic uncertainty. Furthermore, investors may have sustained losses over the short term during periods of market weakness. It is in these circumstances that addiction to risk aversion manifests most acutely. Strangely, risk aversionusually relates only to share markets, even though other asset classes such as bonds at times carry a very high risk of loss.
 
According to Soekoe, one example of the addiction to risk aversion is the use of so called “stable” or low-equity portfolios as long-term investment vehicles. Funds in this category are typically restricted to no more than 40% exposure to shares with the balance invested in bonds, cash and listed property. This equity ceiling brings down the volatility of returns but also severely curbs one’s ability to earn long-term inflation-beating or real returns. 
 
“Stable funds are most appropriate for investors who have a time horizon not exceeding two, possibly three years. If the bulk of your retirement capital is invested in a low-equity portfolio when you realistically expect to live longer than five years, you’re probably being overly risk averse,” says Soekoe. 
 
Soekoe suggests that investors who feel they may be too risk averse should seek appropriate guidance from their financial advisors or chosen fund managers who will be able to recommend funds more suited to a long-term investment strategy. “Going cold turkey and taking on substantially more risk is also not always appropriate,” says Soekoe. “Phasing your investment into a higher risk-return product over several months is a good strategy to average the cost of your investment.”

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