We often talk about returns or yields in the investment community without addressing the risk involved. No risk usually means no returns, unless you have an arbitrage situation. A recent conversation with a friend, compounded with my own observations from acquittances led to this post on my thoughts on risk and risk-adjusted returns. I have omitted some risks such as currency risk since I believe most Malaysians invest in Malaysia without any exposure to foreign currencies. Instead, my interest lies in highlighting an area I hope more retail investors understand and factor in when sharing about returns.
Risk asset classes
Different assets classes carry different risk. For instance, a fixed deposit account is a low risk product. Essentially your only risk is a credit risk on the bank that the deposit is placed with, and if the amount is below the PIDM threshold (RM250,000 – corresponding to around 97% of all Malaysian retail depositors), then it is covered by sovereign Malaysia (which is a credit risk rated A3 by Moody’s). Mutual funds have a higher risk than fixed deposits but a lower risk than stocks. The reasoning is that mutual funds have diversified holdings whereas a stock has a concentration risk on one company. The more stock you hold eliminates the concentration risk and if your portfolio holds exactly the same proportion of each stock represented in the index – voila! you have created an index fund. An index fund does not carry concentration risks on companies but has market risk. KLCI Index for example has a Malaysian market risk or the Dow Jones indices has a US market risk (albeit several international companies have a second listing there).
The graph describes the relationship between risk and return. Mutual funds is missing but it would be placed between Large Company Shares and Higher Yield Fixed Income.
One rule of thumb I try to follow has been to allocate to different asset classes based on your age. The idea behind this is that the older you are, the more sensitive you are to shocks in the market and access to liquidity is more important. The formula is simple, you differentiate between high (growth) and low risk (defensive) assets. Your age corresponds to the % of asset allocation to low risk asset classes, and 100 – your age to high risk asset class.
Using this and the graph above, a 25 year old would invest 25% of their assets in cash and government bonds. The remaining 75% would be in growth assets such as mutual funds, shares etc. The formula means that a 100 year old would have all their asset allocation towards low risk assets which always made sense to me as the ability to withhold market shocks over cycles is harder then.
Mr Money’s assets
If you look at my asset allocation, you will see that I have not been very strict on the allocation rules but they have served more as guidelines and also an reminder to recalibrate periodically (often needed when the times are good and you find it tough to sell down on stock holdings). An observation I made earlier this year on my own holdings is that I am heavily weighted towards property as an asset class. The concentration risk is high but the market risk is somewhat mitigated from the fact that they are in very different markets. I therefore decided to rebalance and channel new liquid funds into riskier assets classes such as index funds and PNB (mutual funds) but not stocks as I unfortunately do not have the time to follow companies. The stocks I hold today are in 7 Large Cap listed entities with global operations and in my opinion strong moats (Warren Buffett reference) in their fields.
Risk-adjusted returns define an investment’s return by measuring how much risk is involved in producing that return. There are different metrics used which includes alpha, beta, R-squared, standard deviation and Sharpe ratio. I would not dwell in that but instead say that it is important that we compare apples with apples. To compare the return from a fixed deposit with a stock is not fair since the underlying risk is very different. It is important to be mindful when investing, but also when talking in general that returns are always connected to the risk taken to receive it. A risk-adjusted return could be negative but the absolute return positive.
Early on in our blog, Mrs Money and myself posted about our investment in a PNB fund and mentioned a comparison with other similar options in the market. In my opinion, there are two options in the market with similar risk and public access. These are fixed deposits and mutuals funds – of which I would limit it to KLCI i.e. an index fund for better comparison and similar risk. The risks are similar with fixed deposits being the lowest due to their PIDM insurance followed by PNB funds (their ownership) and highest risk being the KLCI index fund which also carries a credit risk on the bank issuing the mutual fund. The PNB funds and KLCI are expected to deliver higher returns than a fixed deposit. Unfortunately, KLCIs recent poor performance paints an even clearer picture and it remains to be seen how this will affect the future of PNB funds dividends. Moreover, the cost involved with transacting and managing mutual funds (ETFs would probably be cheaper) makes PNBs a superior choice. I do note that the recent aggressive drive from banks to grow deposits has definitely raised my opinion of the returns from fixed deposits (5% on short term fresh funds).
Money-Makers, how do you view risk when investing?