Risk tolerance the key to your wealth journey (afr.com)

Understanding your capacity for potential losses will ultimately determine whether the path is wealth preservation, creation or acceleration.

Most investors understand they must take on risk to generate a real return – but understanding how much risk to take is the difficult challenge.

Everyone wants to enjoy spectacular returns but not all are equally equipped to take on the concentrated risk required to make them materialise. Understanding individual tolerance to risk is a deeply personal issue and will ultimately determine whether the path is wealth preservation, creation or – for those brave enough – acceleration.

Understanding investment risk is not an easy task. Professional investors will throw around portfolio terms like market beta, volatility and downside drawdown, which can be confusing to the average investor. Losses can be measured in terms of opportunity cost, unrealised mark-to-market losses or the more fatal permanent loss of capital.

In an effort to improve the understanding of risk in different superannuation investment options, the Australian Prudential Regulation Authority introduced a standard risk measure for superannuation products that shows the likely number of negative years a product can be expected to have in a 20-year period.

While potential return is often calculated through very rational eyes, the analysis of risk and loss is often far more emotional and influenced by human behaviour. Even when an investor does all the work in assessing the risk in an investment, the reality when things go south can be far more confronting. Capital loss is always painful but devastating if all the eggs are in one basket.

What does it take to “face into” significant risk and follow an aggressive wealth acceleration strategy?

Warren Buffett famously said that diversification may preserve wealth, but concentration builds wealth. He has always argued that his concentrated investment strategy is lower risk as it raises the intensity with which he considers the opportunity of an investment and the necessary comfort level with its economic characteristics before buying into it.

Wealth success stories usually involve a highly concentrated investment strategy, either through a single-family business or a focused equity holding. These investments are often amplified by decent amounts of leverage.

In Australia, investors are very comfortable borrowing significant amounts for residential property assets or family businesses. In offshore markets, investors are more likely to use leverage for portfolio holdings of stocks and bonds as well. Leverage is a key ingredient in most aggressive wealth strategies.

Concentrating positions to accelerate wealth, however, is not for the faint-hearted. For every success story, there are many more spectacular failures.

Investing for most people is not their core day job and most are simply trying to protect a decent windfall or invest a little surplus funds to satisfy additional safety and financial security.

Even the most successful wealthy investors – those who have taken an aggressive path to achieve their fortunes – will eventually look to diversify their holdings and preserve capital for future generations.

Whether a wealthy family looking to protect capital or a more modest investor looking to add a little return, investment strategies often pivot towards a “core and satellite” approach to managing wealth.

The core provides the anchor of a decent risk-adjusted return while the satellites can be used to concentrate on interesting themes and unique opportunities. This combination will often give investors a diversified strategy better tailored to their goals and risk tolerance.

While such a strategy may not feel as exciting as going all in on the next Amazon, a decent portfolio that delivers a solid 8 per cent compound return will double in only nine years and allow most people to sleep at night.

The potential for return is the fundamental element that attracts investors to part with their capital while the underlying risk is what holds investors back.

So having clear investment goals and understanding tolerance to risk is critical in establishing an investment strategy. While there are examples of people who have concentrated their investments to great success, the reality is that many more have tried and failed.

Most people simply do not have the skill to pick the right investment or the risk appetite to live through the volatility.

Instead, most prudently opt for a diversified investment option where the power of compounding can work its magic.