Many investors—even experienced professionals—often fall into the trap of focusing solely on headline returns, overlooking the crucial question of how much capital can be confidently allocated to each asset. While it’s all well and good to see an asset promising a high return, if the underlying factors—such as liquidity, market depth, and regulatory stability—do not support investing significant sums, the high return ultimately contributes little to the overall portfolio performance. This misstep can lead to portfolios that are not only overexposed to risk but also fail to capture the potential bottom-line effect because only a small fraction of capital can be safely deployed.
In this article, we explore the concept of investability—sometimes informally known as “allocatibility”—which assesses an asset’s practical suitability for your portfolio. We also introduce risk-relative thinking, a method that compares the risks of different investments to ensure that lower-risk assets receive proportionately higher allocations. Additionally, we examine how outcome bias can distort our evaluation of past decisions, leading to an overemphasis on lucky outcomes rather than a sound, process-driven analysis.
Listen to a conversational review of this article:
Below we use some clear numerical examples, aiming to provide a balanced and measured approach that helps investors build more resilient portfolios by recognising that high returns are only valuable when they come with the confidence to invest larger amounts.
Understanding Investability
Investability is a measure of how sensible it is to commit a particular percentage of your portfolio to an asset. Attractive returns alone are not sufficient; an asset must also be liquid enough to trade without causing undue price impact, and its market must be deep enough to accommodate significant capital flows. For instance, an asset that doubles in value quickly might still contribute little to overall portfolio growth if only a modest allocation is feasible. This concept helps bridge the gap between raw performance and the practical management of risk.
Risk-Relative Thinking
Traditional risk metrics, such as volatility, often lead investors to compare assets in isolation. In contrast, risk-relative thinking involves comparing the risk profiles of various assets relative to each other. Consider two investments:
- Asset A: Expected annual return of 12% but with high volatility.
- Asset B: Expected annual return of 8% with only half the volatility of Asset A.
Although Asset A boasts a higher headline return, its larger fluctuations imply a greater chance of significant losses. Risk-relative thinking may justify allocating more than double the capital to Asset B, as its lower volatility reduces the likelihood of catastrophic downturns and improves overall portfolio stability.
Outcome Bias: Judging Decisions by Process, Not Results
Outcome bias occurs when investment decisions are judged solely on their results rather than on the quality of the analysis at the time they were made. An asset that performs well might be celebrated even if the decision to invest was based on overly optimistic assumptions. Conversely, a well-considered decision may be unfairly criticised if unexpected market events lead to poor short-term results. By focusing on robust, process-driven evaluation—assessing liquidity, market size, regulatory factors and volatility—investors can avoid outcome bias and maintain a disciplined strategy regardless of market fluctuations.
Mitigating Catastrophic and Outlier Risks
A critical element of risk management is protecting the portfolio from outlier or catastrophic events—those rare but severe losses that can disrupt long-term performance. Assets with lower volatility not only offer steadier returns but also reduce the probability of extreme downturns. For example, if one asset has half the volatility of another, it is less likely to suffer a dramatic drawdown. In practical terms, this means that an asset with lower volatility may justifiably command a higher allocation—often more than double—that of a riskier asset, thereby mitigating the risk of outsized losses.
Detailed Practical Examples
To illustrate these concepts, consider the following examples using US $ currency:
- Emerging Market Equities:
Emerging market stocks might offer an average annual return of around 15% compared with 7% from developed market equities. However, their higher volatility and exposure to political and economic uncertainties suggest a cautious allocation. For a $100,000 portfolio, allocating about 20% (or $20,000) to emerging market equities balances attractive returns with manageable risk. - Real Estate Investment Trusts (REITs):
REITs in mature markets typically yield around 10% per annum with lower volatility. Their steady dividends and predictable performance allow for a larger allocation—say 30% (or $30,000) in a $100,000 portfolio—enhancing income stability. - Corporate Bonds:
Investment-grade corporate bonds generally return 5% to 6% per annum with minimal volatility. Their fixed-income nature makes them a stabiliser in the portfolio, often justifying an allocation of around 25% (or $25,000) to temper the risks from more volatile asset classes. - Risk-Relative Allocation Example:
Consider two assets:Asset A offers a 12% return with high volatility.
Asset B offers an 8% return with only half the volatility.
Although Asset A appears more attractive on paper, the risk of significant losses is higher. A risk-relative approach may lead an investor to allocate more than double the funds to Asset B, ensuring the portfolio remains robust in the face of market fluctuations.
- Mining Companies:
Compare two mining companies:Company 1 has a historical return of 15% per annum, with a maximum drawdown of 30%. It boasts a market capitalisation of $100 billion and operates 100 sites in 20 countries.
Company 2 delivers a higher historical return of 30% per annum, but with a maximum drawdown of 70%. It has a smaller market cap of $20 billion and operates in only 10 locations across 3 countries.
Although Company 2 offers a superior return, its substantially higher drawdown and smaller, less diversified operation base make it considerably riskier. A risk-relative approach would likely support a greater allocation to Company 1 despite its lower return, as its more moderate drawdown and broader operational footprint reduce the chance of catastrophic loss.
- Managed Funds:
Consider two managed funds:Fund 1 has a historical return of 15% per annum and a maximum drawdown of 10%. It employs a multistrategy approach, trading the world’s largest, most liquid markets both long and short, with the flexibility to exit positions entirely when necessary.
Fund 2 returns 30% per annum but relies on trading relatively illiquid derivatives, with a strong dependence on sustained bullish trends as a single strategy.
While Fund 2’s return is enticing, its reliance on illiquid instruments and a singular market direction increases its vulnerability to sharp downturns. In contrast, Fund 1’s diversified, multi-strategy approach offers greater stability and lower drawdown risk. This difference may justify a higher allocation to Fund 1 in a well-balanced portfolio.
Final Thoughts
Investability goes beyond the allure of high returns; it is a holistic framework that incorporates liquidity, market depth, regulatory considerations, and risk. By applying risk-relative thinking, investors can assess assets on a risk-adjusted basis, ensuring that lower-risk investments—which are less prone to catastrophic drawdowns—receive proportionately higher allocations. This balanced strategy helps counter outcome bias and builds a resilient portfolio capable of weathering both routine market fluctuations and extreme events. Crucially, the ability to invest larger amounts with confidence is what ultimately drives the total return of your portfolio, reinforcing that a high return is only valuable if it can be scaled effectively.
Practical Considerations and Implementation
Translating these principles into practice involves a series of actionable steps:
- Quantitative Risk Assessment:
Use statistical measures like standard deviation, beta, and value-at-risk (VaR) to compare the volatility and downside potential of your investments. This quantitative approach provides clear, objective data to inform your allocation decisions. - Dynamic Allocation Strategies:
Develop a flexible model that allows for periodic rebalancing. For example, if market conditions increase the volatility of emerging market equities, consider reducing their allocation from 20% to a more conservative level until stability returns. - Regular Portfolio Reviews:
Conduct quarterly or bi-annual reviews of your portfolio. This ensures that the underlying assumptions regarding liquidity, market size, and risk remain valid, and it allows for timely adjustments in response to changing market dynamics. - Documentation and Reflection:
Maintain a record of your investment decisions and the rationale behind them. This practice helps mitigate outcome bias by keeping the focus on the quality of the initial analysis rather than on short-term results. - Leverage Technology:
Employ financial software that provides real-time risk analytics and portfolio visualisations. These tools can help streamline the monitoring of volatility, liquidity, and overall asset performance. - Continual Learning:
Stay updated on market trends and evolving risk factors. Regular education on portfolio management techniques ensures that your investment strategy remains robust in the face of new challenges.
By systematically applying these steps, investors can translate the principles of investability and risk-relative thinking into a resilient, well-managed portfolio. This approach not only aims to capture growth but also shields against the adverse effects of rare but severe market downturns, ultimately paving the way for long-term financial success.