What is the right amount of risk to take in your portfolio?

Expectations of investing have been heavily skewed by alluring headline yields on product ads that are primed to attract, but not inform. It is extremely common for investors—novices to seasoned—to chase after the highest returns without paying attention to the downside risks. 

Understanding risk in investing is important for a few reasons. Firstly, without a clear sense of what risk entails, investors may take too little or too much of it, both of which can be costly. 

Secondly, investing is as much an emotional game as it is a number one. Being able to ascertain one’s risk tolerance is key to encumber impulsive behaviours, like panic-selling at market lows.

Thirdly, understanding risk means that you understand the reward you deserve. We have all heard of the general rule in investing: high risk, high reward. The investment product that you park your hard-earned money in should provide returns that commensurate with the risk you take.

How then, can an individual investor like yourself quantify the right amount of risk to take, and consequently, how do you find investment products that fit your risk tolerance?

To help investors decode abstract risk concepts and ratios, the Endowus Insights team sat down with Sean Hu, Investment Advisory Director at the Endowus Investment Office, who provides investment advice and bespoke investment solutions for clients broadly ranging from high-net-worth individuals to family offices.

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How do you measure risk in equities?

Sean: When people think about risk, they usually associate it with volatility. However, volatility can be abstract to some—they might think that the more volatile an investment is, the greater the loss they can suffer. That's true, but it's only half the story. Volatility actually includes deviation on both the upside and the downside, so higher volatility also means you have the potential to earn higher returns.

Maximum drawdown is a more visual, straightforward way of telling a client what the worst-case scenario could be. It's not just any drawdown, but the maximum cumulative drawdown over a certain period of time.

One important caveat: both volatility and maximum drawdown are based on historical data. So if an investment product is relatively new and hasn't gone through a full market cycle or a previous crisis, the maximum drawdown figure may not be representative of the product’s behaviour in a crisis scenario. Hence, investors should exercise caution when considering newer products. 

How do I quantify my risk tolerance, as an investor, and how do I apply these indicators to my portfolio?

Sean: Looking at negative numbers on a screen might not be able to prepare you psychologically for a potential drawdown. A more useful exercise is to take the amount you intend to invest and apply the maximum drawdown percentage to it in dollar terms.

Say you want to invest $50,000 and the maximum drawdown is 30%. Just mentally imagine your portfolio value falling from $50,000 to $35,000. Can you stomach that and hold through to recovery? 

To make it even more realistic, imagine that the $15,000 paper loss doesn't happen overnight, but instead, you are making a paper loss of $500every day over a month, $5,000 monthly over 3 months. If that feels too painful, then you probably need to reduce your risk.

When it comes to matching risk to a goal, we also have to be honest about what's realistic. Say you need $20,000 in three years and you're starting with a $10,000 capital. You're essentially asking to double your money in three years, and that requires roughly 26% returns every year, which is very high by historical standards and very hard to achieve. 

Not to mention, it is extremely difficult to predict performance in the short term. Should there be a drawdown, the required return will be higher to achieve the same target in the same timeframe. Without sufficient runway, there simply isn't enough time for the portfolio to recover if it tanks. 

This is an extreme example for illustration purposes, and it is clear that given the high required return and the short investment horizon, the objective and plan are not realistic.

The value-add of a good advisor is to assess your expectations in detail, and sometimes proposing adjustments to these expectations. We conduct comprehensive assessment and identify blind spots for our clients to construct a portfolio that is tailored to their requirements.

As a general rule of thumb: for a one-to-three-year horizon, cash management and short duration fixed income solutions with lower risk and stable yields might be a suitable starting point. A goal with a longer time horizon could allow for a more equity-heavy portfolio or addition of alternative investments, if it suits your risk tolerance.

How would you advise aggressive, high-risk takers?

Sean: As we do with all clients, we always highlight the different types of risk, not just volatility. There is liquidity risk, which is particularly relevant for alternative investments, and also credit risk, which is more relevant for fixed income instruments, to name a few.

We have clients who would say that they want maximum risk, and are happy to lock up their entire portfolio if it means higher returns. In those cases, we walk them through the same mental exercise of picturing the worst case scenarios, and ask if they could remain invested through these situations.

On liquidity specifically, just because you don't need the money now doesn't mean you won't need it in the future. We always want clients to retain some buffer for liquidity in case it is required down the line. This is especially important when investing in private markets and hedge funds where there can be slower redemption process, withdrawal constraints, and sometimes even lock-ups.

We know that diversification spreads risk, but how much is enough?

Sean: Individual investors may think that owning a handful of stocks means that they are diversified. It also tends to come with a dangerous assumption that these stocks, combined, should outperform the market. 

Doing so exposes one’s portfolio performance to that of these few stocks and is clearly not adequately diversified. For long-term investments, investors’ core asset allocation should be diversified not just by the number of securities, but also by geography, sector and potentially asset class.

Instead of quantifying diversification by the number of holdings, ask what you want to achieve with diversification. If your goal is a long-term portfolio that trends upward over time regardless of short-term drawdowns, then look for products that display those characteristics, like a globally and sectorally diversified portfolio. 

We solve this problem with our digital advisory flow by presenting Core Portfolios that are already globally diversified across sectors as a starting point, ensuring sufficient diversification in our clients’ core asset allocation. 

And if they have a strong conviction in specific themes or want to enhance the portfolio further, such as lower volatility, we offer Satellite Portfolios and single funds to help them express market views. Alternative investments are also available for accredited investors.

Moving on to bonds, why do “safe” assets also need a risk assessment? 

Sean: There are many risks for bonds and we would like to highlight two of them: credit risk and duration risk.

In a scenario where you buy a bond and hold it to maturity, you would be exposed to credit risk—the risk that the issuer defaults and can't repay you. Returns come from interests earned in this case.

For bond funds, not all underlying bonds are held to maturity and can be constantly traded. Therefore, their Net Asset Values (NAVs) can fluctuate. Returns come from both capital appreciation and interests earned.

Using a simplified example and assuming all else being equal, in a falling rate environment, a bond that was issued earlier at 4% yield will be more attractive than a newer bond that is now being issued at 3%. The earlier bond becomes more attractive and buyers may pay a premium for it, hence attracting a higher price. 

Duration specifically measures how sensitive a bond's price is to changes in interest rates. The longer the duration, the larger the expected price movement with changes in interest rates. A bond fund with higher duration is said to have higher duration risk.

It's also worth noting that when comparing fixed income investments, you have to look out for other variables as it is rarely one-dimensional. Comparing a shorter-duration high-yield portfolio with a medium-duration investment-grade portfolio, one would have to consider both credit risk and duration risk at the minimum.

If you can tailor risk-returns with equities and bonds, is there really a place for alternative strategies?

Sean: Global equities provide the growth engine of a portfolio. Global fixed income, think Bloomberg Global Aggregate Index, provides a stable base of return and diversification benefits, which is why a combined portfolio of equities and fixed income has lower volatility than equities alone. But fixed income's returns are historically lower, and a portfolio with higher fixed income allocation will naturally have a lower expected return.

The value of alternatives is that they can either lower volatility with a disproportionately lower drag on returns, or maintain volatility while enhancing return potential. In both cases, they improve the risk-adjusted return of the overall portfolio. 

For clients who feel that even an equity-heavy portfolio isn't sufficient to meet their return target, there are alternative strategies that can boost absolute return, with the same level of or higher volatility if the client is open to it.

One thing to keep in mind when evaluating alternatives: because many of them are valued less frequently, for instance, monthly, you should not directly compare their volatility figures to a daily-priced fund. Instead, use an apple-to-apple comparison of monthly returns for both. 

And beyond volatility, pay close attention to:

1. Liquidity terms: Whether there's a lock-up period, a soft lock-up, and the fund’s specific redemption schedule, and
2. Leverage: Alternative strategies tend to employ leverage to enhance returns, but that also introduces additional risk, and could be a cause for concern if used excessively.

Beyond singularly looking at risk ratios, how do you contextualise risk?

Sean: The short answer is: look at things holistically. If you only look at one figure, you almost always miss the bigger picture.

Take the Sharpe ratio as an example: It measures how much excess return you're getting per unit of volatility, which is useful. But a product with 4–6% volatility, like a bond, will naturally find it easier to achieve a Sharpe ratio of 1, compared to a strategy with 15% volatility. 

If you have an aggressive absolute return target, the more aggressive strategy, sometimes with relatively lower Sharpe ratio, might actually be more suitable—or even required—to achieve the target return. But if you only look at Sharpe in isolation, you'd dismiss it entirely.

Another example with payout yields: Some products can quote impressively high headline distribution yields. But if those payouts are coming substantially out of capital, the fund is essentially just returning your own money to you. You have to look at both yields and total return.

More broadly, a fund manager’s track record, expertise and resources matter greatly. If the portfolio manager responsible for that performance is leaving and there's no clear qualified successor, that's a meaningful risk that no ratio will tell you. This qualitative assessment is an important aspect of the due diligence we do at the Endowus Investment Office. 

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Take risk—with clarity

Investing might sometimes feel like you are taking a blind leap of faith, but it really shouldn’t. 

At Endowus, we believe that investing with clarity means understanding not just the potential returns, but the full risk picture behind every decision. This is why our app is designed to guide investors to understand their time horizon and risk tolerance before a product is recommended.

The Endowus Investment Office also conducts institutional-grade due diligence on every fund available on the platform—assessing not just performance figures, but the robustness and quality of the team behind each fund.

Our client advisors are here to guide so that you don't have to navigate these questions alone. If you would like to better understand the risk profile of your current portfolio, or explore what a suitable one looks like for your goals, speak with one of our MAS-licensed client advisors.