Risk and rebalance
21 April 2020 | Investment principles
It's often said that for a better chance at investment success, portfolio decisions should never be guided by specific moments. This is probably more evident than ever in this volatile market, where daily swings can reach surprising heights and then record lows. Disregarding your long-term investment plan and letting only emotions dictate whether you should cash out or accumulate more at such times can be costly.
And just as there was no need to throw your household cupboards into disarray by panic-buying a year's worth of toilet paper, it is also wise to refrain from panic-buying or selling shares and consequently causing similar havoc to your investment portfolio. Significantly changing your asset mix independent of your long-term goals is risky business. Rebalancing responsibly however is not.
Risk aversion vs Loss aversion
It is understandable for your risk tolerance to have changed a little since before COVID-19. According to the prospect theory, the pain of losing psychologically outweighs the joys of gaining. We're more likely to want to exit the market now to prevent our portfolios from further declining, rather than wait out this storm and see it regain in value and then some.
Risk aversion and loss aversion however is not one and the same. A risk averse investor's purpose is to manage the uncertainty that comes with investing by choosing an asset mix that is relatively more stable (i.e. a preference towards fixed-income products over equities). Their returns might be lower but they are also taking on less risk, and this level of risk also aligns to their investment goals.
A loss averse investor's purpose is not to reduce risk, but rather to avoid loss. This might mean cashing out with the view to protect existing value during a market downturn, or on the flip-side, holding onto investments with large losses because the loss is not realised until it is sold. In the current environment, the first example is perhaps more prevalent.
Sometimes it is difficult to tell the difference between actively managing risk and loss aversion behaviour when emotions are involved. The fear of losing money can impair our judgement and disproportionately influence both our patience and appetite for risk. A way to reduce this is to view investment gains and losses through a long term lens, and not as a point in time. And as always, don't lose sight of your goals – consider if your tolerance for risk really has changed (and will remain changed) in the future, or if it is mostly a reaction to current events.
A timely reminder worth noting is that the primary benefit of portfolio rebalancing is to maintain your risk profile, rather than to maximise your returns.
With the recent market downturn, it might be the case that your portfolio has shifted and is now no longer at the risk-return equilibrium you first set. The general rule of thumb is to rebalance if your asset allocation has drifted by 5 per cent, but do so at a frequency that is still time and cost efficient and with a watchful eye on the tax impact and transaction costs. This means not reallocating with every market swing, and perhaps doing so in consultation with a trusted adviser.
Volatile markets can be deeply unsettling but as history shows, markets are cyclical and in time the market will rebound – we just don't know when that will be. In the meantime, calmly reassessing your risk tolerance and rebalancing may help mitigate the current uncertainty.
Written by Robin Bowerman, Head of Corporate Affairs at Vanguard.
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Robin Bowerman, Head of Corporate Affairs at Vanguard Australia, shares investment and personal finance insights gained from over two decades in the finance industry as writer, commentator and editor.