Strategies for success

Two years after shares hit rock bottom, investors are still grappling with risk. From the Greek debt crisis, political turmoil in the Middle East and the stalled US recovery to Australia's patchwork economy and fears about a carbon tax, it's enough to make investors crawl under the bed along with their savings.

But that would be a mistake.

In the boom years leading up to the global financial crisis, people chased returns and ignored risk.

The danger now is that investors are focused on risk based on fear and not the fundamentals of investing.

''People forgot the fundamentals of risk management by the time the GFC came it was too late. So now there's a re-evaluation of how to manage risk,'' says Russell Investments investment specialist Scott Fletcher.

Risk in the markets, as in life, can't be avoided. It is how you manage risk that counts. But first you have to recognise and understand it.

Risk is one half of the risk-and-reward equation. When people start investing they tend to focus exclusively on returns. It often takes a market crash to appreciate that the management of risk, along with time in the market, is the key to healthy long-term returns.

Academics and fund managers define risk as volatility or variations in the price of an asset or market. They measure this using a statistical measure called standard deviation.

Investors tend to see things differently though.

BARGAIN OR DUD?

''Risk for me is not really about volatility but the probability of loss from an investment,'' says Greg Canavan, investor and author of the Sound Money, Sound Investments newsletter.

''Traders look at volatility because their decision-making is short term. But if you are a long-term investor like me, I'm more worried about the probability of losing part of my money,'' he says.

Academic studies have shown that investors fear a loss far more than they value a gain and that this leads to poor decision-making.

Most people sell when prices fall and buy when they are high, when it would be more rational, and profitable, to do the opposite.

Investor and author of Building Wealth in the Stock Market Colin Nicholson says people need to act in the sharemarket as they do in the supermarket. ''If your favourite brand of coffee is selling for half-price at the local supermarket then you will buy more because it's on special,'' he says. ''But in the stock market people don't buy things when they're cheap, they buy when prices are high.

''Sometimes prices are low because they are bad companies but if they are low because it is the low point in the [economic] cycle then sound businesses may be cheap.'' Fletcher agrees volatility is an incomplete measure of an investor's total exposure to risk because it measures only market risk.

''People need to step back and look at risk firstly from the point of view of their overall wealth,'' he says.

From the perspective of a long-term investor, especially someone in the wealth accumulation phase, Fletcher says there are three key risks to manage:

Risk of capital loss, which might erode your basic standard of living up to and through retirement.Shortfall risk, or the risk of not being able to fund retirement goals.Inflation risk, the risk of returns not keeping pace with inflation.Only after addressing these issues should you consider the market-linked investment risks, which grab the headlines.

During and after the financial crisis, investors fled to the safety of cash investments. ''Cash is great for addressing the risk of capital loss but it's terrible for addressing shortfall or inflation risk,'' Fletcher says.

Risk, like returns, is magnified by debt. If you borrow to buy shares or property and the value of your asset falls then you can end up owing more than your investment is worth.

Looked at this way, even the family home is potentially a high-risk asset, especially if you pay too much for it in the first place, using borrowed funds without a deposit as a buffer against short-term fall in property prices.

QUANTIFY RISK

Professional fund managers use complex computer modelling to quantify risk but there are simple ways you can measure the degree of risk involved in your investments.

The starting point for evaluating risk is the risk-free return from 10-year government bonds.

These are regarded as risk-free because the federal government guarantees to return your capital in full after a set term. All other assets are measured against this benchmark.

The current yield on 10-year bonds is 5.23 per cent. If you buy investments today that involve more risk than a government bond then you need to earn a return of more than 5.23 per cent or you would be better off in the safety of bonds.

The higher the risk, the higher the potential rewards.

''Investing is not about certainty, it's about probabilities and risk and reward. Buying is about ensuring you are accounting for the risks as best you can,'' Canavan says.

When you buy shares, for example, you need to ask if the returns on offer are high enough to compensate for the risk you are taking. This is referred to as the equity risk premium (see graph).

Canavan says people often fall into the trap of thinking risks are increasing because the stock market is falling.

''Perceived risks are increasing, yes, but actual risk is declining because as the price of the market falls, the risk is 'discounted' it's built in''.

In other words, when prices are falling you get more company profits for your buck, with one caveat.

''Just because the price falls, doesn't mean a stock is cheap. You need to look at price relative to earnings,'' Canavan says.

PROTECT YOUR WEALTH

An investor's first line of defence against risk is time, supported by careful asset allocation and diversification. In his book Winning the Loser's Game, US fund manager Charles Ellis likened time to Archimedes' lever.

''Archimedes is often quoted as saying, 'Give me a lever long enough and a place to stand and I can move the Earth.' In investing, that lever is time,'' he writes.

If you invest over long periods of time then shares and property tend to produce higher returns on average than corporate bonds and fixed interest.

Warren Buffett famously boasts that his holding time is forever, although he does advocate selling if a stock price races too far ahead of fair value or the company is no longer a good investment. But he won't sell a stock on price alone if it still delivers the return he wants.

Fletcher says asset allocation can be used to protect your overall wealth from the risk of short-term losses.

Asset allocation is the practice of dividing your money between the major asset classes of shares, property, bonds, cash and alternatives such as gold, hedge funds and infrastructure.

The theory is that falls in one asset class will be offset by gains elsewhere in your portfolio. You also need to diversify within asset classes so a downturn in bank stocks, for example, can be offset by higher returns from resource stocks.

However, Fletcher suggests a broader interpretation of asset allocation based on three separate baskets or components. He argues that your first priority should be to protect your basic standard of living with investments in cash and term deposits, the family home and appropriate insurance protection.

Next you should invest in a well-diversified portfolio of growth and defensive assets to produce the overall return you need to maintain your current standard of living through retirement.

Then you can add a smattering of non-core assets such as alternative assets or Asian funds to enhance your living standards in retirement.

''I call it the aspirational part of the portfolio,'' Fletcher says.

Careful asset selection can also reduce your risk, even when you are buying high-risk assets such as shares. Returns from large companies with a history of profits and good management do not fluctuate as wildly as small mining exploration companies.

Barbara Drury's latest book is out now. Alan Kohler's Eureka Report: Guide to Investing with Barbara Drury (Melbourne University Press, $39.99).

Get to grips with the different types of riskSome investment risks are specific to a single investment while others affect entire asset classes or market sectors. Here are the risks of which you need to be aware:

General market risk: The predictably unpredictable ups and downs of asset prices.Economic risk: The possibility that a cyclical economic downturn or a crisis such as an oil shock will cause panic selling.Interest-rate risk: Affects the cost of borrowing and hence your real rate of return.Currency risk: Movements in the exchange rate affect the returns of overseas investments and shares in local exporters.Credit risk: The risk of default by a bond issuer or other borrower.Liquidity risk: Not being able to access funds when you need them.Manager risk: Returns from a managed fund may fall due to bad decisions, an investment style out of step with the economic cycle, or the departure of key personnel.Sovereign risk: A country in political turmoil or unable to repay its debts may trigger a fall in financial markets.Regulatory risk: The government may change the rules affecting investment returns, for example, superannuation, the resources tax and carbon tax.Sector risk: Sometimes a particular market sector will be marked down on bad news.Specific risk: If a company suffers bad management decisions, or a freeway is built near your property, then the value of the asset will fall.What you should expect from sharesThe equity risk premium is the compensation you should expect from investing in shares rather than risk-free cash or bonds.

A general rule of thumb is that you should expect a 3 per cent equity risk premium.

Using the current bond yield of 5.23 per cent, you would need a total return (capital gains plus dividends) of 8.2 per cent from shares to make it worth the risk of investing.

In reality, there are times when the perceived risks of shares outweigh the rewards on offer and investors demand a higher risk premium.

Share trader Colin Nicholson says another way to look at the equity risk premium is the difference between the earnings yield of the market and the 10-year bond yield.

Put simply, the earnings yield is the inverse of the price earnings (PE) ratio - the current share price or index value divided by earnings per share. Hence, the earnings yield is 100 divided by the PE ratio.

In January 2009, just before the sharemarket hit rock bottom, the 10-year bond yield was 4.1 per cent and the All Ordinaries Index earnings yield was 12.2 per cent (see above).

At the end of June this year the bond yield was 5.21 per cent and the sharemarket earnings yield was 7.2 per cent.

The equity risk premium was fairly constant until the bear market

began in 2008, when it widened dramatically.

''What this represents is fear,'' Nicholson says.

Bond yields fell as bond prices rose - vice versa for shares - and investors fled to the safety of bonds. Things came back to ''normal'' in 2010 but the equity risk premium has started to widen again.

''This suggests fear in the market again but less than in 2008 to 2009. There's no compelling reason to buy shares now, or to be away from the market,'' Nicholson says.