Portfolios of retail investors are generally composed of a number of diverse asset types. The level or tolerance to risk between one investor and another differs and hence, not only the composition of portfolios but also the diversity in terms of asset allocation, asset type selection as well as maturity profile of underlying investments will characterise a portfolio and make it distinct and unique from any other portfolio.
In addition to investments such as equities, bonds, money market instruments and/or foreign currency, investor’s overall portfolio of investments might also include investments/exposures to pension funds, life insurance policies with a savings element embedded in them as well as real estate.
Investors must be aware of the correlations between the returns of different assets, and how such returns behave during differing market conditions when evaluating the risk of a portfolio.
For example, the returns on High Yield Bonds are generally less volatile than those on equities, and over recent years, there has been a strong relationship (correlation) in their returns. On the other hand, there is a weak relationship between returns on High Yield Bonds for instance and the returns on the ultra- High Grade Sovereign Bonds, such as the German Bund.
When viewed as part of a portfolio and not in isolation, the offsetting pattern (or weak relationship) of returns on these two assets serves to stabilise the risk of the overall portfolio.
Investing in assets with payoffs which are inversely related is called hedging and is one of the key contributors to reducing overall portfolio risk. An insurance contract could be viewed as such. Another form of an indirect hedging instrument within a portfolio is gold.
Historically, the price of gold and equity markets have had very low correlation, however equity investors might have in the past wished to have been exposed to gold in their portfolios in an attempt to reduce overall risk.
Another form of reducing overall portfolio risk is by means of asset diversification within a portfolio of assets. Retail investors are generally guided to spread their risk by investing in a wide variety of assets so that an exposure to the risk of any particular security is limited and that performance of that one security does not materially impact (in either a positive or negative way) the overall performance of a portfolio.
Asset managers constantly strive to achieve the optimal risky portfolio, by not only delving deep into the macroeconomics of global capital markets and through a thorough stock selection process, but also use mathematical and statistical tools such as the concept of covariance of asset returns in their day-to-day as well as medium term asset allocation decision making process. The covariance measures how much the return on two assets move together.
Whilst the concept of covariance might be highly technical for the retail investor to grasp, investors must ensure that the constituents (and their underlying risks) within their investment portfolios are commensurate with the level of risks that they are willing to undertake.
Financial markets are changing every day and portfolios should reflect this and be dynamic in the way that they are managed, so that the market outlook and current portfolio asset allocation tie in with investor’s respective risk profile and investment horizons.
This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.