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The risk that matters

03 October 2011 Allan Gray
Delphine Govender

Delphine Govender

Investment managers define risk in different ways. Some define it as volatility, while others define it as being different. According to Allan Gray, however, the most important risk in investing is the risk of permanently losing money.

Volatility essentially measures how much an investment’s return varies from its average over time. By defining risk as volatility, the relationship between the intrinsic value of an investment and its price is downplayed, as is any intrinsic risk of the company’s operations or financial structure, says Delphine Govender, portfolio manager at Allan Gray.

“The problem with using volatility as a gauge of risk is that it is mostly an indicator of changes in the perceived value of an investment based on the fluctuations of historic return patterns. It therefore gives you no sense of the possibility of an intrinsic looming threat to returns.”

Another popular interpretation of risk is that risk is being different, as measured by tracking error. Tracking error is the statistical amount by which the returns of a particular share differ from those of a benchmark. A share whose returns differ widely from a specific benchmark (usually an index) is considered to have a high tracking error and is therefore considered high risk.

“We accept that for an investor whose objective is for returns to mimic an index, tracking error is a relevant risk measure. However, for an investor aiming to create long-term wealth, defining risk as tracking error simply doesn’t make sense,” says Govender.

“To us, however, investment risk is not about how variable a share’s returns are over history, either versus its own average or that of any pre-selected benchmark. It is simply the probability of permanently losing money from an investment.”

She says it’s important to be aware not only of the possibility of loss, but also of the potential magnitude of the loss. If a fund has a long-term history, investors can assess the largest peak-to-trough decline in returns over the life of the fund, also known as the ‘maximum drawdown’. It’s also important to consider how long it takes an investment to bounce back following a decline.

Benjamin Graham, the father of securities analysis, maintained that a potential decline in the price of a share does not ultimately raise the risk of loss if the decline is temporary and if the probability of selling during the decline is low. Graham applied the concept of risk solely to a loss of value, which may be realised through actual sale; caused by a significant deterioration in the company’s position; or, more frequently, may be the result of overpaying for an investment relative to its true intrinsic worth.

“Since our primary definition of risk is the probability and the extent of capital loss, we always try to invest in businesses when share prices are well below our assessment of the company’s intrinsic value and we are offered some protection should things turn out worse than we forecast – in other words, a margin of safety exists.”

She says Allan Gray believes that to invest where value is exceptional is not only the lowest risk, but also the most rewarding strategy. “In our opinion, the best predictor of returns is the price you pay for the investment relative to its intrinsic value and risk.”

If a particular investment appears overpriced, Allan Gray considers it risky and won’t purchase it for their clients. “Conversely, we consider it prudent to invest in assets that we believe offer exceptional value even if they are out of favour and not represented in the average portfolios. This means that our portfolios often differ markedly from those of the average investment manager.”

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