In 2010 Jack’s portfolio made a return of 35 per cent whereas Jill’s portfolio made a return of 17 per cent. Which portfolio performed best? If one had to provide this information and ask this question to a randomly chosen sample of investors, the majority would quickly reply with the ‘obvious’ answer – Jack’s! That would only be correct if all other things were equal, which is hardly ever the case when speaking about risk and more precisely risk tolerance/appetite.

In order to answer the above question we also need to know how much risk both Jack and Jill were willing to expose themselves to in their personal investment portfolios. This is because the risk profile of individual and institutional investors may differ, creating opportunities or restrictions in the manner in which investment portfolios are managed.

When structuring an investment portfolio, the portfolio manager will be guided primarily by the return objectives and risk parameters relating to that specific portfolio (apart from other characteristics such as tax status and time horizon). The risk parameters will be drafted according to the investor’s ability and willingness to take risk. The former relates to the size of the portfolio, relative to the investor’s return objectives and time horizon, whereas the investor’s willingness to take risk is based on psychological factors.

Sometimes an individual’s ability and willingness to take risk are pointing in opposite directions and in such circumstances a portfolio manager should always respect the more conservative of the two. Imagine Jack was reaching retirement age this year and only has his investment portfolio to live off; given he made a return of 35 per cent last year, Jack may be willing to take on more risk than he is actually able to expose himself to.

In this case the investment manager should opt for a more conservative investment approach ensuring that Jack’s investment capital is not exposed to excessive levels of risk (unless specifically instructed by Jack to maintain a more aggressive investment style).

On the other hand, investors may have the ability to take on more risk but lack the willingness. An example of such investors are young professionals who have a huge amount of human capital (salary earning potential) ahead of themselves which is steady and certain, who prefer to invest in cash deposits and fixed income securities (reflecting low risk appetite) rather than focusing on capital growth (reflecting higher risk tolerance). These young professionals are living the early stages of their life cycle which, combined with their stable income stream (via their salary), allows them to take on more risk.

Therefore, when investors are assessing the acceptable level of risk within their investment portfolio, they should consider both the stage in their life cycle as well as the type of human capital the individual investor is exposed to. For example, a university professor would have a very steady and certain income stream which would therefore allow that individual to take on more investment risk.

On the other hand, property sales people whose income is completely dependent on property sales would want to take on less risk with their investment portfolio. This would mean less volatility and more stable returns from their investments to compensate for the high level of volatility in their human capital.

How can one assess their ability and/or willingness to take on risk? As mentioned earlier, one’s willingness to take on risk is almost entirely based on psychological factors. How much volatility can one stomach with respect to the value of their investments?

Investors will also note that their personal risk appetite is different with respect to different asset classes. For example, local investors would normally be more tolerant with volatility in their bond investments rather than with their property investments and they would normally be more tolerant with their property investments than with their equity investments.

Then what about the ability to take risk? More often than not, this is easier to figure out than willingness because it can almost be worked out mathematically. One’s ability to carry risk primarily depends on three main factors; the investment returns the portfolio needs to generate (as opposed to desired returns), the amount of capital being invested to achieve these much needed returns and finally the length of time one is willing to invest for.

Example: Jack will be retiring next year and requires an income stream of €2,000 per month / €24,000 p.a. Jack’s portfolio is currently worth €1,000,000. Therefore Jack’s portfolio needs to generate 2.4 per cent net of tax and net of any portfolio management fees. Assuming Jack’s interest is subject to 15 per cent withholding tax and Jack’s investment manager charges him 0.75 per cent to manage the portfolio, than Jack’s portfolio needs to generate 3.6 per cent in order to have the desired annual income stream.

Given the current interest rate environment Jack’s investment manager should be in a position to generate the return required without exceeding Jack’s ability to take risk. On the other hand, if Jack only had €250,000 to invest, then the required rate of return on the portfolio would move from 3.6 per cent to 12.1 per cent. In order for Jack’s capital to generate this level of return his investment manager would definitely have to exceed Jack’s ability to take on risk.

Hence, it is always important for all investors, retail or institutional, to think in advance and do some homework (possibly even guided by their investment manager) prior to investing their hard earned savings. Going forward, investors should be in a position to achieve their investment goals whilst remaining within their own specific risk parameters.

This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.

www.curmiandpartners.com

Mr Micallef is an investment executive at Curmi and Partners Ltd.

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