Understand where you want to position your portfolio on the Risk Reward Spectrum

The traditional concept of the risk reward relation is a graph, with Risk on the horizontal axis, reward on the vertical axis and the relationship between the two the upward sloping line in the graph:

The theoretical relationship depicted in the graph is linear; however, this pattern does not hold in practice. As one transitions into higher risk categories, both positive and negative potential outcomes may increase substantially. Consider visualising the range of possible investment results on different points on the risk reward line as a normal distribution, represented as follows:

Now we take this normal distribution of outcomes, and we plot it on the risk return line, keeping in mind that the riskier investments have a much wider range of possible outcomes, both positive and negative or put differently, the riskier investments have a higher volatility. This gives us a graph that looks as follows:

Source: The most important thing by Howard Marks

To view this differently, your range of potential outcomes increase as you move up the risk: return line with volatility increasing by investing in riskier assets. Your profit could be greater as you progress to the right, but your loss could also be substantially greater. Potential outcomes detailed between the red lines recognising that it widens as you move out on the risk axis:

Within the range of potential outcomes, how do you then manage the risk in your portfolio?

  1. Ensure you acquire investments at a good price, preferably below its underlying intrinsic value.  Regularly check your intrinsic value for every investment against the ever-changing price that Mr. Market offers you.

  2. Quality investments at the right price helps you can weather temporary downturns more effectively, but you must have paid a reasonable price for such investments.

  3. Ensure your portfolio is appropriately diversified in terms of the number of investments, industries, different geographies and asset classes.  This is a principal aspect of risk control in a portfolio but very hard to accomplish, especially in an overvalued market  where many asset classes display co-movement.

  4. Ensure you do not use debt to potentially enhance portfolio performance.  Debt increases the inherent risk in a portfolio exponentially, especially in a drawdown, when margin calls are made and you are forced to sell.

  5. Carefully consider your risk appetite to select the most appropriate portfolio for your circumstances.  You want to balance your offensive with the defensive for the desired outcome.

Structuring your optimal portfolio

At Celestial we offer four core portfolios’, all at different intervals on the risk reward graph.  We manage the first 4 elements of risks management listed above by allowing for a margin of safety, acquiring only quality individual shares and ETFs, appropriately diversify all our portfolios and never using debt.  The only outstanding item for us to consider jointly is, where do you want to your portfolio to be positioned.

Determining your risk profile

  1. What is your ability to take risk?

  2. What is your willingness to take risk?

“. . . not everything that can be counted counts, and not everything that counts can be counted”  - Einstein

Disclaimer

The information and opinions on these pages were prepared by Celestial Capital Partners (Pty) Ltd and/or one of its affiliates. The information herein is believed to be reliable and has been obtained from public sources believed to be reliable. Celestial Capital Partners makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute the current judgement of the author as of the date of this report. They do not necessarily reflect the opinions of Celestial Capital Partners and are subject to change without notice. Celestial Capital Partners has no obligation to update, modify or amend these pages or to otherwise notify a recipient thereof if any opinion, forecast or estimate set forth herein, changes or subsequently becomes inaccurate. This report is provided for information purposes only for sophisticated and professional investors. This report does not constitute a recommendation to buy, sell or hold any interest, shares or other securities in the companies mentioned in it nor does it constitute financial advice. Past performances are not indicative of future performances. Celestial Capital Partners is a Juristic Representative of IBEX Capital (Pty) Ltd, FSP No. 49055.