It’s time to double check that your risk profile matches your tolerance for market downturns

Investors may not have fully appreciated the level of risk they had 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 Prize winner Daniel Kahneman found that investors feel twice the pain of a loss than the joy of an equivalent gain.

Assessment of comfort levels

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

Investors can use this as an opportunity to assess their comfort level with recent losses and whether their risk profile matches their tolerance for market reversals. As Mike Tyson said: “Everyone has a plan until they get punched in the mouth.”

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

The measure is based on the number of years of negative annual return a strategy can expect over a 20-year period. A typical balanced strategy would be expected to have five negative returns over 20 years, while a stock portfolio might be expected to average six negative annual returns over a 20-year period. This would no doubt surprise many new to investing.

Many commentators now draw parallels with the period 2001-2002 after the “technological shipwreck”. Income and high-multiplicity businesses have not been penalized. Outflows from equity markets have been significant over the past year, sentiment indicators are at reasonably bearish levels, and major technical support levels feel well below the prevailing market level.

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

The fundamental question facing the markets is what level of interest rates will be required for inflation levels to return to the central bank’s target ranges.

Many experts argue that cash rates will have to be well above neutral to smooth demand in markets for goods and services. The pace of quantitative tightening through central bank balance sheet shrinking is making this cycle much harder to judge.

The possibility of a policy error is high. But central banks do not seek to create recessions. Even though the market spends its time trading with all the nuances, central banks have the big picture in mind regarding the path of interest rates; in the US, this is indicated by dot plots. But every policy meeting will always be live and heavily data-driven.

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

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

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