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Investors Shun Risk

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A relationship exists between investment risk [4] and expected return [5].

The safer the asset, the lower the expected return. The greater the investment risk, the higher the required return. Or it can be a tad more technical [6] if you like.

Investors should take an objective view of investment risk. Unfortunately, investors tend to be emotional creatures and these volatile times lead people to become fearful of investment risk.

So what is happening? And what should you do as an investor?

Investors Shun Risk

According to Morningstar, Shaken Investors Shun Risk [7].

The demographic bulge of aging baby boomers is becoming ever more risk-averse as it continues its march toward retirement. At the same time, investors as a whole have become financially and emotionally scarred by bear markets. The result, says financial-services consultant Goshka Folda, has been a flight to safety.

The first sentence makes sense. Younger investors have a significant time horizon. Young investors have more time to ride out the increased volatility of higher risk assets. As such, young investors should seek out relatively higher risk assets to reap higher expected returns.

As investors approach retirement, there is less time available to deal with highly volatile investments. Safety and certainty are more important. That is why you see older investors shift their capital into lower risk asset classes. And receive lower returns.

The second sentence though, reflects how emotions play a significant role with investors. Emotions should be avoided when investing. That said, I realize how hard it is to maintain a disciplined, unemotional, investment strategy when markets are moving like a roller coaster.

How This Impacts Asset Allocations

Of the more than $3 trillion in investible assets of financial wealth, more than $1 trillion is sitting in deposits (Source: Household Balance Sheet Report, 2011 Edition). In addition, close to another $1 trillion consists of short-term instruments with maturities of less than one year.

A lot of investors appear to be heavily invested in low-risk, low-return assets.

While this low risk approach might be reasonable for retirees (but beware that a 65 year old retiree may live until 90, so may still desire/need some higher risk assets to finance a 25 year retirement), a low risk strategy is probably not suitable for younger investors.

Asset allocation [8] is extremely important for investing success. It should not be based on emotion and fear of loss. Your asset allocation should be unique [9] for you, based on your personal situation.

What to Do?

“After so much damage, clients are now in a risk-averse stance,” says Folda, “But the reality is that many households still need growth, they need exposure to at least some equity.”

“So volatility, while damaging for everybody,” says Folda, “can be opportunity for advisors to even further underscore the importance of good advice and solid solutions in establishing the right risk profiles for portfolios.”

I think there are a few keys to effectively deal with volatile markets.

Investors need to construct investor profiles [10] and Investment Policy Statements [11]. These will determine a proper target asset allocation and help maintain long-term focus during periods of short-term volatility.

A properly diversified portfolio [12] will reduce portfolio risk without lowering expected returns.

Low cost investments such as open-ended index mutual [13] and exchange traded funds [14] will help with diversification and cost-effective investing.

While I understand that many advisors, banks, brokers, etc., want to sell investors innovative new products (that usually are quite profitable for the seller), be cautious. Minimizing your costs [15] is a key to maximizing long-term success. Do not pay someone else 1-2% of your capital each year simply to purchase the flavour of the day.

Dollar cost averaging [16] will also assist in dealing with volatility and staying disciplined.

If you use these techniques you will reduce emotion in your investment decisions. This will improve your portfolio construction and your probability of long-term investment success.