Is now a good time to be in stocks? Should currency risk be hedged? Questions of that kind, often seen in the financial media, tend to confuse means with ends. The answer in every case is “it depends”.
Think about a group of friends, dining out at a restaurant, and talking about the property market. One mentions she’s found the “perfect place”, a five-bedroom renovator’s dream, out of town with a three-car garage and a pool.
For another of the group, though, this sounds like a nightmare. This guy lives alone (“what am I going to do with five bedrooms?”), doesn’t drive, doesn’t swim, loathes home maintenance and works long hours in a high pressure job in the city.
It’s a similar story with investment portfolios. What’s right for one person may be wrong for another. The “right” strategy will depend on the nature of each person’s goals and their sensitivity to any number of risks.
A 25-year-old saving for a deposit to buy a new home in five years may need less exposure to equity markets than someone of the same age saving for their retirement. A stockbroker, whose working income is affected by the equity market, may prefer less of that sort of risk than a doctor or gardener.
Many investment professionals will seek to apply a mathematical formula to these questions, presumably with the goal of finding the most efficient or “optimal” trade-off between the return the investor is seeking relative to the risk they are willing to take on.
But people are more complex than that. For a start, it’s tough to identify every single risk an investor might be sensitive to. And even if you can identify the risks, they can’t always be boiled down to a number. The bottom line is that while models can be helpful guides, they can’t account for every variation in people’s lived reality—their circumstances, needs, appetites, values and goals.
This is where plug-and-play cookie-cutter models meet their limits. And that in turn is why advisors focused on the changing goals and needs of each individual have a vital role to play.
Take a 25-year-old starting out as a lawyer. His expected future work earnings are significant and he can afford to take bigger risks with his meagre financial capital. Twenty five years later, he’s left law and is working as a high school teacher. He’s earning far less and he has diminishing human capital, but he now has more financial capital. His appetite for risky investments may be much lower.
So the “right” investment strategy doesn’t just vary among people. It can change as our life circumstances change. All these inputs are what advisors can take into account in arriving at an appropriate asset allocation for each client’s needs.
Someone averse to volatility and with a short horizon will place a priority on preserving capital. So their portfolio may have a large quota of high-quality short-term government bonds. Another person with a longer horizon and able to withstand greater ups and downs may be better off with a balanced portfolio of global equities, listed property and global fixed income.
Yet another variable to consider is the difference between what people say they are ready for and what they actually experience. So some investors may declare they have a big risk appetite, only to discover otherwise when the market falls dramatically and their portfolio loses significant value.
Bringing perception closer to reality is another role for an advisor, who can explain the range of expected outcomes using historical data. The investor may decide after all this that they can’t tolerate that sort of risk, in which case the answer may be for them to save more or even moderate their goals so they can sleep soundly.
Scientists will tell you that the average in a set of numbers can disguise a wide variance in individual data points. It’s similar with human beings. No-one is “average”. Our circumstances, risk appetites, attitudes, values and goals can vary in countless ways, not just from person to person but within a single lifetime.
So it follows that we need a wide range of investment solutions to match the varied requirements of different people and we need to reassess those solutions as each person moves through life.
Or to use less scientific language, there are different strokes for different folks.
Jim Parker, Dimensional Fund Advisers