The enigma of riskJohn Leiper - Senior Portfolio Manager
Risk is defined as a ‘situation involving exposure to danger’. Risk-averse investors would rationally seek to minimise this in their portfolios. In most cases, ‘danger’ refers to the possibility of capital loss. Alternatively, risk could represent unacceptably low returns. In each instance risk relates to performance.
Performance and risk are two sides of the same coin. Investors should take on additional risk only if they are compensated for doing so by the expectation of higher returns. Because ‘expected’ returns refer to the future, which is unknown, assessment of risk can be highly subjective.
Alternative definitions of risk include ‘volatility’ or the ‘deviation’ of returns from an average. Such statistical measures are backward looking and make mathematical assumptions which may not reflect the real world. This came to light during the 2007-2008 financial crisis when financial institutions significantly underestimated sub-prime mortgage risk in the US.
Risk means there are multiple potential outcomes, with uncertainty over which occur and, therefore, the potential for loss when disadvantageous ones do. To provide an example, a ‘lucky’ investor might generate strong returns in a bull market but take on significant risk doing so. Meanwhile, a ‘prudent’ investor delivers similar returns for far less risk. Had the environment turned negative, risk would have become a far greater factor. Warren Buffet summed it up best when he said, “only when the tide goes out do you discover who’s been swimming naked”.
Higher risk comes from higher prices, or more specifically, insufficient compensation for exposure taken. Because markets follow cycles, investor perceptions can become distorted over long periods of time. The belief that risk is low, that investment will surely lead to profits, an absence of caution, a diminished fear of loss and the over exuberance of missing out, are all clear signs of heightened risk.
Risk should not be avoided. It should be intelligently managed, or controlled, to maximise returns. Tavistock Wealth controls risk by targeting long-term volatility across the risk progressive Centralised Investment Proposition. Whilst historical volatility can be observed and monitored against this target range, ongoing adherence depends on future returns.
Volatility in the ACUMEN Portfolios and Tavistock PB PROFILES is slightly below the long-run target range. This is because recently, market volatility has dropped to all-time lows. However, we believe volatility will return to historical averages. Portfolio volatility is also below IA sector averages, yet performance since inception remains above average. This suggests superior risk-adjusted returns.
An alternative would be to shift further along the risk curve. However, riskier investments do not reliably produce higher returns. If they did, they wouldn’t be ‘risky’.
In our view, current stretched valuations result in risk being decreasingly associated with higher expected returns and increasingly linked to lower returns. The likelihood is therefore that taking increased risk now will lead to the possibility of higher than expected future losses.
This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Tavistock Wealth Limited.
Want to know more about the Equity Markets?
Please contact us here:
Those stocks that outperformed during the corona crisis are the same ‘winners’ that outperformed before the crisis.
The recovery in US equity prices, from the corona crisis, has been one of the most rapid in history.
China’s economy has transitioned, from an industrial export-led model, towards services.
Commodities are nothing if not cyclical. They rise and fall in value with remarkable consistency over time.
Quantitative easing, or QE, is where a central bank creates money to buy bonds. The goal is to keep interest rates low and to stimulate the economy during periods of economic stress.
In January 2019 Jerome Powell pivoted from a policy of interest rate increases and balance sheet cuts to interest rate cuts and, later that year, balance sheet expansion.
Over the last decade, the Fed has increasingly resorted to unconventional monetary policy, such as quantitative easing, or QE, to stimulate the economy.
Flying the global economy into the ground from 35,000 feet will go down as one of the most difficult and controversial decisions in the history of mankind.
In response to the corona crisis, global central banks have unleashed a tidal wave of liquidity.
Tavistock Wealth is the investment management arm of Tavistock Investments Plc. The investment team is comprised of 7 highly educated and talented professionals.
One question I get from advisers and clients, more than any other, is why global equity markets have bounced back so far.
In the early stages of the Corona Crisis of 2020, the global economy faced a liquidity crisis.