WA Super News

Take the plunge: understanding risk vs return

15/11/2018

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Risk is part of life. Every day, we’re confronted by decisions that relate to risk; sometimes these fall within our comfort zone and sometimes outside it. Our comfort zone is the yardstick with which we measure our attitude to risk.

You might be uncomfortable trying a new type of food, or on the other hand, you might love the thrill of skydiving. It’s your attitude to risk that makes you different and, ultimately, influences your decision to bite or jump.

In the same vein, all investors take on some form of risk. For retirees, risk – in general - can be described as the chance that you don’t achieve the investment returns you need to meet your retirement dreams. Risk can be categorised into various types that will affect how your nest egg grows or shrinks over time.

The risks that affect your investment

The last two months is a stark reminder that investing always has two sides. On one side, positive returns are your reward and on the other side, negative returns are your risk. There has been a great run up in markets in the past 10 years; however, the past two months are a reminder that markets also fall. It’s inevitable, they will go up and they will go down. On average though, share markets deliver negative annual returns around 30% of the time.

Whenever you invest, there is a trade-off between risk and return. Generally, going for higher returns involves greater risk of short term losses. It’s important that you know that there are risks to every type of investment and to every type of strategy. By understanding the relationship between risk and return you can determine the level of risk that you’re comfortable with.

These different types of risk can affect your investment at any time.

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Estimating the likelihood of risk impacting returns… 

The biggest risk is losing the money that you’ve invested in your super or retirement account: that’s known as absolute risk. There are two elements of absolute risk: 

  1. Frequency – how often returns are negative; and
  2. Magnitude – the size of the negative returns.

There’s no better example of absolute risk than the 52% fall in the Australian share market between November 2007 and February 2009; that’s absolute risk at its most stark and - whilst this is an infrequent event - it was the magnitude that damaged portfolios.

Within each of our four pre-mixed, diversified portfolios, we include the estimated frequency of a negative return and the expected magnitude of a severe negative return alongside our expected return objective. An example for MyWASuper (Super Solutions) is below. You can view each investment option for Super Solutions (SS) here and Retirement Solutions (RS) here

Expected magnitude of a severe negative return2

To illustrate the probability, the chart below highlights that – in 9 out of 10 cases – we’d expect returns to be within the positive and negative ranges shown by the blue bars. But there is always a risk that the magnitude of losses may be steeper and more severe which are represented by the yellow diamond.

One-year expected returns for WA Super’s 4 diversified portfolios

One year expected returns for WA Supers 4 diversified portfolios2

This past October was a stark reminder that investing has two sides. On one side, positive returns are your reward and on the other side, negative returns are your risk. There has been a great run up in markets in the past 10 years; however, the past few weeks are a reminder that markets also fall. It’s inevitable, they will go up and they will go down. On average though, share markets deliver negative annual returns around 30% of the time. 

…and managing risk by diversification

We believe it’s important to consider inflation risk, sequencing risk and longevity risk, along with the frequency and magnitude of absolute risk when constructing our investment portfolios. And the best way to manage these risks is to build diversified portfolios with a mix of asset classes.

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We ensure our portfolios have a suitable level of exposure to shares, but we actively invest in other opportunities that behave differently to shares; especially when markets move.

We’ve designed our portfolios to be fit for purpose for the financial profile of our membership. Ensuring that only an appropriate amount of risk is taken to return the maximum possible investment, means we focus on reducing the chance of members experiencing sustained losses or negative returns.

This long-term view and focus delivers a smoother path through volatile markets, as our diversified portfolios are robust in a range of economic and market scenarios. This approach supports our mission to ensure that each member prevails through the possible worst of financial times and benefits in the best of times.


Source: Airplane illustration https://www.vecteezy.com/vector-art/237774-skydiver-jumps-from-an-airplane-illustration

 

 

 

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