The time to recheck your risk profile matches your tolerance for market downside

Investors may not have fully appreciated the level of risk they were carrying in their investment portfolio. Equity allocations have been rising for years as capital market forecasts dictated higher allocations to risky assets in hopes of hitting real return targets.

Psychologist Amos Tversky and Nobel laureate Daniel Kahneman found that investors feel twice as much pain from a loss as joy from an equivalent gain.

Assess comfort levels

This is called “loss aversion,” and it means investors hate losing money far more than they enjoy making it. Feeling uncomfortable with negative returns is normal human behavior, but doing nothing is not a viable investment strategy.

Investors can take this opportunity to gauge their comfort level with recent losses and whether their risk profile matches their tolerance for market downturns. As Mike Tyson said, “Everyone has a plan until it’s punched in the mouth.”

In an attempt to educate investors on investment risks, the Australian Prudential Regulation Authority (APRA) has introduced seven standard risk measures for pension products to provide a common basis for comparing strategies.

The measure is based on the number of years of negative annual returns a strategy can expect over a 20-year period. A typical balanced strategy should have five negative returns in 20 years, while an equity portfolio should average six negative annual returns over a 20-year period. This would undoubtedly surprise many new investors.

Many commentators now draw parallels with the period 2001-2002 after the “technological sinking”. No income and high multiple businesses were sanctioned. Flows out of equity markets have been strong over the past year, sentiment indicators are at reasonably bearish levels, and key technical support levels look well below the current market level.

In this environment, it is difficult to judge when the markets are rebounding and whether we have reached a turning point or just another violent bear market rally.

The fundamental question imposed on the markets is what level of interest rates will be needed to bring inflation levels back within the central bank’s target ranges.

Many experts argue that spot rates will need to go well beyond neutral to dampen demand in commodity and service markets. The pace of quantitative tightening through central bank balance sheet reduction makes this cycle much more difficult to assess.

The risk of political error is high. But central banks are not looking to create recessions. Although the market spends its time trading all the nuances, central banks have the big picture of the path of interest rates – in the US this is indicated by the dot plots. But every policy meeting will still be live and heavily dependent on data.

It will be important to understand the reaction function of central banks as they weigh the risk-reward ratio of an action against the consequences of a type one or type two error.

Central banks will be walking a tightrope in hopes of achieving a soft economic landing with a benign inflation outcome. And private investors are hoping they can engineer the Goldilocks outcome to avoid one of those dreaded years of negative returns.

About Mike Stevenson

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