Risk can be a difficult concept to construct a clear framework about, but without such a framework it can be hard to think about how best to measure and manage risk.
Our clear framework for risk is simple:
- There are two dimensions of investment risk,
- There are two levers you can use to help manage that investment risk.
In this piece we'll set out how we think about the two dimensions of investment risk, and then in our next piece we'll look at the two levers you can use to manage the investment risk. Then in a later piece we'll also look at some of the behavioural, or emotional, aspects of managing risk.
First, The Risk Of Permanent Loss
First and foremost investment risk is the possibility that you might lose some or all of your capital.
Immediately we find ourselves dealing with the fundamental truth of investment risk … it’s all about uncertainty. Clearly if you knew you were certainly going to lose money then you wouldn’t invest, but instead it’s that you expect to make money on your investments but you recognise that’s not certain and that there is a possibility of losing money. Or, if you look at it from the other direction, if you knew exactly how your investments were going to unfold then there wouldn’t be any risk. So the pithy summary is that riskier investments are ones where there is more uncertainty about the outcome.
There are many ways an investment could lose money. It could be that circumstances unfold in an unexpected way in the overall market (for example shifting economic fundamentals) or in an individual company (for example new competitors, or regulatory changes, or even criminal behaviours inside or outside the firm). That wide spectrum of possible causes and fault lines is one of the main reasons investors get overwhelmed and confused by “risk”. But distil it down and the essence is that these are all variations on the primary risk that you might lose some or all of your invested capital.
Second, The Risk Of Underperforming Your Target Return Or Benchmark
Investment risk is also about the possibility that you might not reach your investment target.
It could be that you need a certain level of return to finance your needs and objectives, and a prolonged period of underperforming that required return will have serious financial implications for you. We fear this is an under-appreciated risk in KiwiSaver in particular, where there’s a lot of focus on fees but not on long-run net returns after tax.
Parallel to this is the risk of underperforming your benchmark return. Fund managers feel this acutely, and it’s why many equity funds are constructed as quasi-index funds – to minimise underperformance risk. The difficulty here is that if you want to get an above-market return (what’s referred to as “alpha”) then you have to do something that’s different to the market, and that will entail you’ll also have periods of underperformance too since no investment strategy or style can be perfect all the time.
You Need To Balance Between These Two Risks
Note that there’s a tension between these two investment risks. If you tilt towards “safer” investments in order to reduce the risk of permanent loss then you may increase your risk of under-performance, and vice-versa. So the challenge is to balance your portfolio or fund between these two competing pressures.
No one promised this would be easy or cost-free.
Summing It Up
There are two simple elements to investment risk … the risk of permanent losses, and the risk of underperformance. All of the other “risks”, including the risks we have to list in our formal fund documents, are just sub-sets or causes of those two over-arching risks.
At heart both these two investment risks speak to the uncertainty of investing. Not surprisingly then the levers we can use to help understand and manage investment risk flow from how we manage uncertainty. We’ll cover those in our next piece.
A Few Quick Thoughts On Investment Risks In Other Asset Classes
We run a fund that invests in listed equities, and so much of this discussion is in the context of how listed equities behave. But the same two fundamental investment risks apply across all asset classes.
For example, many New Zealanders have invested in residential property. There’s a perception that these are low-risk investments but they still entail the risk of permanent loss of capital (some causes of which can be insured against, such as fire, but other causes can’t be, such as leaky homes or regulatory changes) and the risk of underperformance (there are different returns between cities and suburbs, and even property by property).