Investing is exciting because to some extent, you don’t have full control over the outcome. To make wise investments, you have to evaluate the market, the vehicles, and risks involved. The rest is all about taking a leap of faith and sticking to the course in the face of uncertainty.
Having expounded on 2 great retirement schemes for expats in the previous article, our Finance Expert Freddy Meinderstma is back with more good advice on how to measure your investment risk. To sum up his investment advice: “Instead of attempting to predict the future and beat the market, focus instead on what you can control, balance your choices (or cushion risky investments with risk-freeones) and position yourself to reap positive rewards.”
Measuring Your Investment Risk
Investment advice typically involves assessing your risk profile first. From here, finance advisors will recommend an allocation between fixed income and equities for your investments suited to your risk profile.
You could use several methods to measure your risk while you invest, and manage volatility or downside risk. One useful technique is called the Constant Proportion Portfolio Insurance (CPPI). This structure invests dynamically between risk free and risky assets to allow investors to take part in the upside of risky assets and still protect an aspired level of the initial investment.
Here’s An Example To Illustrate The Point:
Suppose the initial investment amount is USD 100,000, and the aspired portfolio level to maintain is USD 90,000 (should not fall below this number). This level is known as the absolute Floor and the difference of USD 10,000 the so-called cushion. We start by establishing the permissible loss in the price of risky assets first, which can be derived from the volatility of the risky asset, such as equities. Assume that from the volatility and amplitude of equities, a downside risk of 25% is established.
The amount permissible to invest in equities then is: (1/0.25) X (100K – 90K) = USD 40,000. Thus USD 60,000 is invested in risk-free assets such as US treasury. In case the equity portion falls with 25%, it will be sold and swapped for Treasuries. Holdings will fully be in US Treasuries in such case.
Investors may choose to rebalance their allocations periodically, for instance if the portfolio grows to USD 110,000 the amount permissible to invest in risky assets increases to: (1/0.25) X (110K – 90K) = USD 80,000. The use of this CPPI method is based on value at risk and illustrates the potential downside in your portfolio.
Making Your Investments Work Over Time
This helps further inform the investor on his or her given risk profile, through measurement of one’s investment risk along the way. Over time, here’s how the method works (illustrated below)—with the treasury portion maturing at the level of the initial investment:
The factor to invest and allocate into risky assets is called the multiplier. In the above example, the multiplier is 4, based on our measurement of downside risk. An alternative way to manage risk would be to allow the multiplier to fluctuate within a certain range. A wide variety of instruments is available to manage your portfolio risk, and you can implement the CPPI method without the use of derivatives.
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