Investment Surgery
What is risk?
Risk, being one word but not one number, can be variously defined but essentially risk means that more things can happen than will happen. However, perhaps a better, though more unusual, place to start is with Donald Rumsfeld’s infamous knowns and unknowns quote: “There are known, knowns. These are the things that we know. There are the known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. These are the things we don’t know we don’t know.”
Although ridiculed at the time, Rumsfeld quite correctly suggests that while some risks are known and are readily quantifiable, others – the known unknowns - are not so easily forecasted and calibrated. Then there are the unknown unknowns – the unthinkable extreme events –- that cannot always be anticipated but whose impact can be truly devastating.
What are the key risks investors face?
The risks that reside within any asset portfolio can arise from a variety of sources and assume a number of forms. Those that are common to all asset classes are called portfolio risks. First, there’s market risk: the fact that broad market movements are generally unpredictable. Then there’s exposure risk, comprising factor risks, liquidity risk and counterparty and default risk.
Factor risks are the macroeconomic and company specific risk factors that any asset portfolio is exposed to – those largely identifiable risk factors that define the characteristics of the portfolio. These include the portfolio’s exposure to economic growth, inflation, interest rates, the exchange rate, the oil price and the unique specific risks posed by the companies in which the portfolio invests, whether via an exposure to equity, bonds or other financial instruments.
Liquidity risk arises when it proves difficult to realise an asset at the quoted market price because two-way trading in the asset has dried up. This is evidenced by a widening of dealing spreads – the difference in the buying and selling prices as a consequence of there being a multitude of sellers but few, if any, buyers.
Counterparty and default risk is when the party with whom you are dealing or the entity in which you are invested fails to fulfil their contractual obligations, typically as a result of encountering financial difficulties, causing investors to lose most, if not all, of their investment. Counterparty and default risk can be quantified by reference to credit rating agency credit ratings, credit spreads and credit default swap spreads. The lower the credit rating and the higher the spread, the greater the perceived counterparty and/or default risk.
Finally, there’s the risk of your fund manager(s) succumbing to behavioural biases, or sub-optimal behaviour, resulting in sub-optimal portfolio construction and poor performance. We consider these biases in more detail in the behavioural finance learning topic.
In addition to portfolio risks, there are risks specific to each asset class. For instance, within fixed income portfolios, there is interest rate, event and seniority risk to consider and within equity portfolios, volatility, beta and tracking error, to name but a few. We consider these risks within the various asset class learning topics.
Can risk be managed?
Portfolio risks and those specific to individual asset classes can be managed, as opposed to totally mitigated, through sensible diversification and/or by using derivatives, such as futures, forwards, options and swaps.
Diversification is all about not having all your eggs in one basket. To put it more formally, diversification quantifies the extent to which, by combining two or more assets, the weighted average of their risks, as measured by their standard deviation of returns, can be reduced whilst preserving the weighted average of their returns. Often referred to as the only free lunch in investment, diversification is measured by the co-movement between two assets and is underpinned by a statistical measure termed correlation. The lower the correlation between two assets, the greater the diversification. While relatively stable in the long term, diversification can break down very quickly when financial markets dislocate and all asset prices decline in unison, just at the time when diversification is most needed.
Is risk management an exact science?
Risk management is far from being an exact science. In fact, arguably there has been a fundamental misunderstanding of risk and an illusion that all risk is manageable, not to mention a system that remains grounded in outdated theory and statistics. Perhaps most importantly, the mathematics applied in risk management can only take you so far: there’s a big role for judgement and intuition.
Finally, it is essential to expect the unexpected, as while history can prove instructive to a degree, things will happen that you didn’t expect.
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