The enigma of risk

John Leiper - Senior Portfolio Manager

Understanding Risk

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.

Recognising Risk

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.

Controlling 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.

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