Episode Details

Episode 49 – Bike paths, Bitcoin, and Risk Budgets

I go for a bike ride most Sundays. Wherever I can, I ride on a bike path. Often there is a road running parallel to the bike path. Very often, cyclists are on the road when they could just as easily be on the bike path.

Now I understand why they do this. It's because you can go faster on the road than on the bike path.

But the thing for me is, you don't get killed on a bike path. No cars to get under the wheel of.

I know it doesn't happen often on the road, but cyclist definitely get hit, and occasionally killed by cars.

So why would anyone choose to ride on the road when there is a perfectly good bike track option?

I ask because I often see the same thing with investing. People could use a low risk option and achieve their objectives. Yet they chase higher risk options.

So that's what we'll be exploring in today's post - high risk and low risk investment options, and when it makes sense to use each. Because I suspect that when investing, some people ride on the road, not realising that there's a perfectly safe bike path only meters away.

A good place to start is the concept of a Risk Budget. This is a term used by professional money managers, and can certainly have an application in investment planning for normal people like us too. Institutional investors have a myriad of analysis tools that allow them to optimise their portfolios for their risk budget, but for the rest of us, it's enough to just understand the concept and reflect on whether we're behaving logically in this context.

The idea is that a given investor has a certain amount of risk that they're prepared to stomach. Most typically in this context risk is referring to the volatility of potential outcomes. So a low risk investment might say produce returns in the +9% to -3% range, while a higher risk investment might have a range of returns between +15% and -%10. So the higher risk option has a broader range of potential outcomes, and therefore greater uncertainty.

Let's say that given your time frame and general temperament you're after an investment in that low risk range. One way to approach your investment planning would be to think in terms of having a certain amount of risk that you're prepared to take on – to spend if you like.

Now one extreme way you could spend your risk budget would be to use a small amount of investment money to buy lottery tickets, and leave the remainder as cash in the bank. Most likely the lottery tickets will prove worthless and so you'll lose money there, but your bank deposits will earn a small amount of interest, and so in combination your outcome will be within an acceptable range.

Another way you might deploy the same risk budget is to put 30% of your investment amount into international shares, and the remaining 70% in term deposits. Or perhaps you put 20% into a really aggressive investment, perhaps that includes borrowings, and place the other 80% in a bond fund.

The point is, there are all sorts of ways that you could structure your portfolio whilst still retaining the same total amount of risk. This is the concept of a risk budget. You have a certain amount of risk to "spend", and as an investor, you want to try and find the most efficient way to spend it – get the most bang for your buck I guess.

Generally, a key way investors try to optimise within a given risk budget (even if they've never heard of the concept) is to diversify. So in the examples I gave earlier, none of the potential solutions involved a single investment.

Diversification is really important when thinking about risk, because another important consideration when planning an investment portfolio in a risk budget context is that you are trying to find the most efficient use for that level of risk.

So if you're prepared to take on a certain level of risk, what you don't want to do is chose an in