Anyone who is familiar with the investment industry will know that the most common way to handle the risk level of portfolios is to divide them into three categories: high, medium and low risk. This is based mainly, if not exclusively, on the proportion of equities. Give or take a few per cent either way, 75% equities entails high risk, 50% medium risk and 25% low risk. Although this basic categorization is subject to criticism on various grounds, it remains at the core of the investment process for many people, and if done properly, is indeed helpful. Certainly, every investor needs to be aware of this truly fundamental issue before investing.
However, equally fundamental to the level of risk, is the state of the market at the time of investment. This too, can be high, medium or low risk. Furthermore, the prevailing level is as important to your investment success as the asset allocation - the mixture of equities, bonds, cash or other asset classes, and above all, the equity percentages referred to above. (For more, check out Asset Allocation: One Decision To Rule Them All.)
How to Divide Markets into Risk Levels
Firstly, it is important to understand that we are not talking about timing the market (mainly, though not only for equities), but merely about whether it is at a relatively high or low level or somewhere in between. For any professional or informed amateur, this is not particularly difficult to determine.
A look at how much the market indexes have risen or fallen over the last few months and years gives you a good idea, and there are all sorts of sophisticated ratios and charts that can provide confirmation and additional insights. The financial press and other media are also always full of both objective and subjective news and views on just this issue. Additionally, there is market sentiment. If people are euphoric and optimistically buying like mad (which is of course reported in the financial press), the market is high and risky. If people are depressed, pessimistic and selling like mad, it is low and less risky.
Inevitably, these levels are just a guideline, but a pretty good one. Putting a lot of your money into equities in a market that is relatively high is far riskier than putting in less or waiting until there is a correction, or better still, a crash. This principle is indisputable. (Learn more in our Market Crashes Tutorial.)
Accordingly, various possibilities emerge, with a high-risk market and a high-risk portfolio being the most dangerous situation (shown in red below), and a low-risk market with a low-risk portfolio being the most benign (shown in dark green). And then there are the options in between, also shown in the matrix. For instance, a high-risk portfolio in a medium-risk market is a step less risky (shown in orange) than the red zone and a medium-risk portfolio in a medium-risk market or (low-high and high-low!) are truly medium risk (shown in blue), at least in theory. The higher-than-average risk combinations are thus shown in orange, and the lower than average in pale green.
Matrix of Market-Level and Portfolio-Risk (Asset Allocation) Combinations
|High and medium-high risk||High-risk market/high-risk portfolio||High-risk market/medium-risk portfolio||Medium-risk market/high-risk portfolio|
|Medium risk||Low-risk market/high-risk portfolio||Medium-risk market/medium-risk portfolio||High-risk market/low-risk portfolio|
|Medium-low and low risk||Low-risk market/medium-risk portfolio||Medium-risk market/low-risk portfolio||Low-risk market/low-risk portfolio|
In other words, there is a continuum, ranging from a double high-risk situation at the one extreme and a double low-risk combination on the other. Because low-high and high-low are the same in theory, this yields six specific levels of risk, rather than the usual three from the standard pie charts. This provides a considerably more detailed and realistic model. It is also quite different than merely extending the usual three levels to medium-low medium high etc., which still does not take the state of the market into account. (Read Five Things To Know About Asset Allocation for more.)
The Benefits of the Extended Model
The failure of the usual simple asset allocation models and associated pie charts to consider the level of the market can be considered a serious weakness. This is the case, because the state of the market is so vital to the process and likely investment success.
It is also worth noting that the usual approaches to asset allocation tend to factor in the investor's age, preferences and so on into the level of portfolio risk, but the level of the market itself is generally considered only peripherally, particularly in initial discussions by brokers and advisers. After all, they want you to buy now.
Implications of the Model
The main implication is that investing when a market is red hot will likely lose you money, and investing a lot can ruin you. By contrast, a particularly interesting implication is that a portfolio that is a bit on the risky side, considered in isolation, may be just fine if the market in question is relatively low at the time of investment. And of course the converse is also true.
A particularly important implication of the model and the matrix is that you should adjust your portfolio in line with market developments and cycles. That is, if you start off after a crash, in a low-risk market with 75% equities and 25% bonds, as equity prices rise, you should move down towards the 50/50 level, at some point or gradually. If things start to get euphoric and frenetic, you could wind it down to 25% equities. In other words, you cannot control the state of the market, but you certainly can control your exposure to it, by reducing the proportion of equities and of other risky assets that you hold.
Most investors should never have more than 75% equities or less than 25%, but if you are really confident and risk friendly, or the opposite, you can wind it up to 90% or down to 10%. (To learn more, see Asset Allocation Strategies.)
Theory and Practice
This is always the catch, but the model is in fact pretty reliable. Of course, one can judge the market incorrectly, but then again, this is not about a precise timing of peaks and troughs. All that is required is to figure out if, particularly for equities, but also for real estate and other assets, the market is overheated, relatively low, or somewhere between.
Asset allocation models should be neither too simplistic nor too complex, and they should always take account of the state of the market. An extremely simple model factors out too much of what really matters, but a very complex one is unwieldy and may even become unusable or useless. Plugging it all into some fancy software won't solve this problem either.
The two most important elements of investing are figuring out how much goes into stocks or anything else that is volatile and risky, and assessing the relevant market risk at the time. These two factors are intertwined, but they are not the same thing.
For most investors, it is just not worth investing, certainly not a lot and possibly at all, in a market that is sizzling hot. Even one that is medium-high is not for the faint hearted. Consequently, at the most basic level, you should assess not only the intrinsic level of risk of your portfolio (in isolation according to asset classes), but also the relative level of risk of the relevant markets. It is the interplay between the two that determines the true risk of your investment. (For more, read Buy When There's Blood In The Streets.)