Risk needed for returns, but what risk to focus on?

For PSG Asset Management CEO, Anet Ahern, risk at a very high level is simply the chance that things could turn out differently to what was expected and whether one could lose all or some money.

 

"We believe that risk is the probability of losing money on a permanent basis and therefore actively manage it throughout our investment process. We reduce risk by having a structured, evidence-based process that is repeatable and consistent.”

 

After the market crash and financial crisis a few years ago, many people mistakenly believed that with a bank or savings account that they were taking on little risk. This does come with a different kind of risk. Inflation will over time erode the value or purchasing power of money. To grow wealth rather than just preserve it, investors need to consider higher growth investments than savings accounts.”

 

"There is a whole range of different types of investments across the entire risk spectrum to meet different needs. At PSG it ranges from money market funds, which are lower-risk investments to local and global equity focused funds, which require a longer term view,” according to Ahern.

 

To design a portfolio, the best is to talk to a financial adviser about your appetite for risk relative to your specific goal or objective for some or all of your money. Many simplistic approaches have in the past been to categorise an investor according to a ‘risk tolerance’ - usually low, medium, and high. This would then be used to match an investor with a combination of investments designed to meet their specific return and risk profile.

 

Ahern says "This thinking has advanced somewhat in acknowledgement that for specific parts of our portfolio, we are willing and may in fact need to take more risk to achieve a higher return. For other parts of our portfolio, together with our emphasis on not losing money on a permanent basis for our clients, we respect clients’ different time horizons in which case, we tailor the portfolio construction to include different combination of investments.”

 

Measuring and evaluating the risk is a little more complex. While an investor’s overall risk tolerance or risk tolerance for a specific part of their portfolio can be categorised or marked on a scale, an investment’s risk is multi-dimensional.

 

To evaluate an investment, one should consider the different types of risk that could affect its performance in order to determine whether the investment is appropriate. Risk is most often measured by calculating the standard deviation (level of variability or uncertainty of the historical returns or average returns of a specific investment relative to its past). A high standard deviation indicates a high degree of risk. This is a very one dimensional way of looking at risk, but it does highlight how volatile a portfolio has been over a particular period.

 

According to Ahern, "Which risk metric one focuses on depends on the style or investment philosophy of each investment manager. If a manager believes that they need to be different to the market in order to outperform, using a measure of risk that tracks how different an investment is to the market as a measure of risk (tracking error), wouldn’t be a meaningful measure of risk for that approach, particularly if their process shows that they do a good job over time of looking after clients’ capital.”

 

Ahern says "We have a bottom-up process that manages risk at the stock level, and rigorous application of investing in quality companies with strong business models, strong management teams at an appropriate margin of safety.

 

We also believe that diversifying our portfolios across a broad spectrum of market cap sizes, industries, geographies and currencies and being disciplined about avoiding expensive instruments and buying undervalued instruments reduces risk. We look for investment opportunities that will provide us with a sufficient margin of safety and carefully analyse ideas to be sure that the possible returns are more positive than they are negative. We refer to this requirement as ‘little downside and sufficient upside’” she explained. Most investment managers give an indication of the risk level of their funds by providing measures of risk on their fund factsheets.

 

One of the most commonly used absolute risk metrics is standard deviation, a statistical measure of how much an investment return varies around a central tendency or average return. This number tells you what happened for a period of time, but it doesn’t tell what happened along the way.

 

Another popular risk measure is drawdown, which refers to any period during which an investment’s return is negative relative to a previous high mark. The aim of measuring drawdown is an attempt to see how large the negative return was (how bad it was), how long the bad period or negative return lasted and how many times there have been negative or bad periods.

 

"It always pays to learn more about investing and the risks associated with different types of investments and investment styles and approaches. It may also be worthwhile for an investor to speak to a professional financial adviser about the risk that he or she can take on to achieve certain financial goals and over what time period. They may discover that their tolerance for risk is lower than expected or that they need to take on more risk in order to meet financial goals” concluded Ahern.