The riskiness of risk-aversion
Over the past five years, the financial markets have “crashed” several times, destroying value. This has eroded investors’ confidence in traditional diversification. Many investors are now very risk-averse and looking for what they consider to be safe ha
Both institutional and private investors looking to preserve pensions and savings are confronted with a widening “funding gap” between expected liabilities, and future assets and revenues. Whilst the financial crisis did reset the asset level lower, it didn’t reset the future liabilities. Very risk-averse investments and the resulting low yields in investors’ asset mix will not make significant progress in reducing this gap.
Indeed, many of the “safe havens” are not as risk-less as assumed. The explosive growth of the money supply has exposed the US dollar to inflation risk, for example. We cannot be certain when inflation will increase but we need to know the consequences for our long-term wealth. In addition, long-dated US Government bonds, another perceived “safe haven”, have rallied as interest rates have fallen. However, with rates now rock bottom and likely to rise, investors with portfolios containing long-term sovereign debt may be stuck with low interest rates and negative returns.
Risk-aversion amongst investors is also manifested by a flight to shorter-term instruments as perceived protection from volatility. As the value of various assets has suffered over the past few years due to the Euro crisis, large groups of investors have shortened their investment horizons.
However, investors need to adapt to a new reality and adjust their timelines if they want to achieve their goals and take advantage of “time horizon arbitrage”. Consider Warren Buffet, for example, whose approach to managing risk involves investing in assets he plans to hold forever. 20 years may be a reasonable investment timeline for many equity shares, as well as for real estate and other less liquid investments. This may seem like a long time, and investors won't experience many 20-year cycles during their lifetimes, but pension funds and governments need to plan ahead for several generations. Investors should be well aware of investment timelines and how they fit into their investment mix.
It is also essential to diversify strategically as well as tactically. For all investors, combining diversification and a long-term investment vision is a better approach to ensure good future returns than over-allocating to “safe havens”.
Recent history, when many investment categories lost value simultaneously, may have served to undermine belief in the value of diversification, but in the long-term it remains a highly important risk management tool. Investors need to look carefully at the “building blocks” of their asset allocation and use the right benchmarks that reflect future success, rather than those based on past success. For example, capitalisation-weighted indices reflect market shifts of the past; equal weighted indices and alternative types of indices may be better indicators of future growth and return.
Alternative investment opportunities, like real estate, hedge funds and tactical asset allocation, have a weaker correlation to listed markets, and can stabilise portfolios without creating adverse long-term impact on returns. Risk diversification is also necessary within alternatives such as real estate, including different types of risk and return sources, properties, geographies and cash flow characteristics within the category.
In the long term, the greatest risk investors run is remaining risk-averse for too long, building portfolios based on short-term phenomena, not long-term realities, and therefore falling well-short of their goals.
Risk management’s role is not to avoid risks but to ensure that they are intended, well-understood and compensated in order to help achieve longer-term investment goals. A long-term vision allows “time horizon arbitrage”; by basing actions on the long term, investors can achieve results by taking advantage of others’ reactions to short-term market events. This of course means riding out short-term volatility, which requires discipline and patience. As a risk manager, it's important to be aware of volatility, but to avoid being intimidated by it. A long-term approach can capitalise on the short-term perspective of others, adding to and holding assets in your portfolio that will become valuable in the future.
