Judging the Risks in an Investment

Risk assessment should be the first step when choosing any investment.

You cannot avoid risk entirely, nor should you – it’s the price you pay for the prospect of higher returns. Equities generally deliver higher total returns over the long term than bonds because they’re riskier. Similarly, bonds – which carry some risk, but much less than shares — deliver more than a savings account at a bank.

Sometimes the type or scale of risk you’re taking on is not obvious. In Britain more than a million people suddenly discovered their savings – held through with-profit policies and pension plans – were at risk in Equitable Life, a giant mutual life insurer that was long regarded as one of the most secure. Equitable got into trouble because it misjudged its risk in guaranteeing future investment returns – an expensive mistake for most of its policyholders.

On the other hand, most investors are too frightened of risk.

Investing in equities can be less risky than it seems, as the longer you hold them, the lower the risk. The US stock market has lost as much as 30 per cent in a single day, yet over 20-year periods has never failed to deliver a positive real return.

Hedge funds have the reputation of being high-risk, and many are — yet some are particularly low-risk. They can be effective instruments for reducing the average risk in a portfolio.

There are many different kinds of investment risk. Here are the more important ones:

Specific. The risk that a company or sector will lose value because of circumstances which only or mainly affect them. Examples would be the loss of a contract accounting for most of a company’s earnings, or the catastrophic impact of the 9/11 terrorist attacks on airlines.

Market. The values of a whole category of assets, such as shares, may plunge because of changing conditions or perceptions not specific to the particular asset in which you’re invested. An obvious example would be the bear market in global equities that struck us in March.

Default. You lose your money through fraud, a suddenly adverse business environment or managerial incompetence that devastate the entity you’ve invested in. Some years ago there was the highly publicised case of Enron, for instance investment asset and the income from it are denominated falls in terms of your own monetary unit.

Interest rate. Unexpected increases in rates hit the value of many investments for several reasons. One little-understood but important one is that it tends to boost the rate used to discount the future returns from an asset, which has the mathematical effect of cutting the present value of that asset.

Political. Unwelcome surprises such as riots, a terrorist incident, the outbreak of an epidemic or the election of a radical government can have a sudden adverse impact on the value of assets directly or indirectly linked to the country concerned.

Management. The risk that your company investment loses value because the managers have lost focus or drive, perhaps because of the unexpected loss of an outstanding chief executive, leading to loss of market share, erosion of profit margins and balance-sheet deterioration.

Liquidity. The danger that you won’t be able to sell your investment with ease, without sustaining significant loss. This is greatest when investing in a “narrowly-traded” market – there are few buyers and sellers at any time – such as the shares of small companies.

Purchasing power. The risk that the return on a “locked-in” investment – one that can only be cashed after a set or minimum holding period — will be poor after adjusting for inflation.

Choosing who’s to manage your capital: a hazard oft-overlooked

Some risks are less well-known, or only apply to specific assets:

Opportunity cost. The risk that you’ll lose out from failing to invest in a fast-rising asset because you don’t have the cash or the nerves to do so.

Last-day or critical-day. Where much of the redemption value of your asset depends on asset prices on the last day of its term, or where there is no certainty about the date when it will accrue, such as on the death of the investor.

Manager selection. The risk that the performance of the management to whom you have committed long-term savings, as in a pension fund, turns out to be far worse than the past record on which you based your choice. There can be many reasons for this, such as focus on sectors that go out of favour or loss of a talented manager.

Individual investors often base their strategies on fallacious perceptions of risk. For example, they are worried about the risk of a 5 per cent loss of original capital but ignore the risk of failing to get a 5 per cent gain when the market moves up. Professionals judge both as similar levels of investment risk.

An American study showed that the risks of primary concern to mutual fund investors were the chances of loss of original capital; of fluctuations in the value of their investment; of loss of real value because of inflation; and of not having enough money to achieve set goals (such as paying for a child’s university education at a future date).

There are several ways in which the risk in a security can be measured:

Volatility. This encompasses all the factors which have contributed to movements in price in the past such as interest or exchange rate fluctuations, profits, tax rates and changes in market perceptions.

The metric most used by professionals to gauge this is standard deviation (SD), which measures the ratio of average upward and downward movements in the price of an asset in relation to its mean or average price or return, typically over the past 36 months.

By comparing the SD of a fund, for example, with its peers’, you can determine whether or not greater, or even undue, risks have been taken to achieve a higher return. However, SDs share with other ratios based on historical experience, the deficiency that they may not be a good guide to the future.

Volatility over the period considered may have been unduly high due to special factors, as happened with American bonds in the mid-1990s when the US Federal Reserve unexpectedly raised interest rates and there was a financial crisis in neighbouring Mexico.

Correlation. A portfolio invested in a greater number of securities will nearly always have a lower risk than one invested in a smaller number, even if all the securities are high-risk.

Diversification is a basic strategy for reducing investment risk. Good managers ensure that any strategic move into higher-risk assets is accompanied by greater diversification.

The benefits of spreading risk in this way are enhanced by selecting assets which do not have a close correlation with one another – that is, their values do not move in the same direction, or at least not simultaneously.

A share listed in Turkey, for example, is likely to have a very low or even a negative correlation with one listed on Wall Street, as the forces moving its price are likely to be location-specific, such as consumer demand, political instability, or changes in the exchange rates of the national currency, interest rates or tax.

A company depending entirely on export sales is likely to do well precisely when a firm depending on imported products or components is suffering from a weak national currency. Putting one in your portfolio would neutralize the risk in the other. 

The metric used to gauge this kind of risk is the correlation coefficient (CC), which shows the extent to which changes in the value of one asset have been linked to changes in the value of another.

A ratio of one shows a complete positive correlation (the values of both securities have in the past moved in the same direction, to the same extent, at the same time). A CC of 0.40 would show only a weak linkage, while a negative one of 0.80 would indicate a strong tendency for values to move in opposite directions.

For practical purposes, any CC above 0.70 is regarded as strongly positive; in the range down to 0.40 only moderately positive; figures below that show little linkage.

By careful selection of assets in different markets, managers seek what is known as the “efficient frontier” – the point at which return of the portfolio as a whole is likely to be highest relative to overall risk.

Managers of indexed or “tracker” funds, however, actively seek a perfect positive correlation with the benchmark they are committed to tracking.

Performance. Several measures are commonly used to gauge whether a fund manager has been taking on undue risk relative to the return he has delivered, and relative to his peers’.

The most popular is the Sharpe ratio. It’s the extent to which there has been return in excess of a notional risk-free rate, such as the yield on 90-day US Treasury bills, divided by the fund’s standard deviation. A simpler modified form, commonly used, ignores the deduction of a risk-free return.

A deficiency of this ratio is that it can be very high for completely different reasons – because of aggressive, relatively high-risk fund management, or because of very cautious, low-risk management.

The Treynor ratio is similar to the Sharpe, but instead of the return in excess of risk-free rate being divided by the standard deviation, it’s divided by the Beta – which is a measure of how a fund has performed relative to a benchmark, usually a sector average or an index.

Another measure of performance-related risk is maximum drawdown. This shows the maximum amount an investor could have lost had he or she bought or sold a share or fund unit at the worst times. It is expressed as a percentage of purchase capital, and is a kind of worst-case scenario based on historical experience.

Consistency measures the risk that a fund is likely to underperform relative to its peers in any one period, such as a year. It is based on the frequency that a fund manages to achieve outperformance, such as appearing in the top quartile, quintile or even decile (25, 20 or 10 per cent).

Funds’ “star” ratings are often based on a combination of Sharpe and consistency measures.

Your views may differ considerably from others’

There are other aspects of risk to be considered, such as exposure to exchange rate or interest rate changes.

However, all standard measures of investment risk suffer from the limitations of being based on history (the future may not mirror the past), and of not taking into account the situations and attitudes of the individual investor.

Not only will different investors have different views on what constitutes risk, but also their capacity to accept risk will differ. Clearly a retired couple with little income and a small amount of assets will be less able to risk fluctuations in their investments than a young couple years away from retirement.

Assessment of individual sensitivity to risk should be the starting-point of planning any investor’s portfolio.