Understanding Risk

One of the key principals of investing is that in order to receive a higher return an investor would need to invest in assets which could potentially exhibit higher risk. This is more commonly known as the risk-return trade-off. For example a money market investor would be willing to accept a low return, on the premise that the capital invested would be relatively safe (low risk), whereas an equity investor would be willing to tolerate higher risk in exchange for a potentially higher return. What is interesting is that the definition of risk is not homogenous amongst investors. Warren Buffet famously quotes risk as the permanent loss of capital, however there are various other ways in which we can quantify the risk of an investment. In this article we explore some of the risk metrics commonly used by investors, their advantages and potential shortcomings.

Standard Deviation

Standard deviation is probably the most common risk metric used in order to quantify risk. Simplistically standard deviation shows how the observed data (returns) varies around its mean over a selected time period. Consider Investment A and Investment B below. Let us assume that the mean monthly return (using 12 months of data) of both of these investments is 3% (indicated by the solid black line), while the actual monthly returns are indicated by the dotted red line.

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Investment A  Investment B

What can be observed is that the monthly returns of Investment B exhibit a higher variation around the mean than Investment A, resulting in a higher standard deviation. This characteristic is more commonly referred to as volatility. A key advantage of this measure is that it is relatively simple to calculate using an excel spreadsheet. However, one of the key shortcomings of the standard deviation measure is that it penalises both large positive and negative deviations around the mean. This is a particularly important point as an investor would not be too concerned about their portfolio increasing in value, but would rather be more concerned with how it performs on the downside.

Downside deviation

Downside deviation corrects the abovementioned shortcoming of the standard deviation metric. As its name suggests downside deviation only measures the variation of returns below its mean (or a minimum acceptable return). This minimum acceptable return will be set at zero if an absolute return is required. Downside deviation does not discount positive deviations from the mean (or minimum acceptable return) as being a bad outcome.

Drawdowns

Capital loss is often a concern for many investors. A drawdown analysis assists an investor to graphically evaluate how an investment/fund has managed to protect capital during various investment periods. The analysis indicates the cumulative loss over a certain period from peak-to-trough. For example, the investment/fund will experience a drawdown when its value declines below its previous high point. The investment/fund will recover from this drawdown once its value reaches the previous high point.

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The chart above shows a drawdown analysis of the Coronation Balanced Plus Fund, Stanlib Balanced Fund and the All Share Index. In this particular example the Coronation Balanced Plus fund exhibited a much better drawdown profile than both the Stanlib Balanced Fund and the All Share Index. We can thus infer two important points from this:

1. The Coronation Balanced Plus Fund was more successful in protecting capital than the Stanlib Balanced Fund

2. The Coronation Balanced Plus Fund recovered its losses much quicker than the Stanlib Balanced Fund

This analysis is useful when evaluated over extended periods of time as it often emerges that certain funds are better at protecting capital during market downturns.

In conclusion, while it is important to quantify these risks for particular investments/funds, within a portfolio context, it is vital not to lose sight of the goal of the investment. Often investors become obsessed with the short term volatility or fluctuations in their investment values and they lose sight of the bigger picture. Long term returns should not be sacrificed as a result of short term volatility if investors have a sufficiently long time horizon for an investment. The investor’s risk profile (willingness to take on risk) is not the only thing that should be considered, but also the ability to take on risk. The matrix below illustrates this trade-off.

For example, an investor has a time horizon of 20 years as the capital is only needed at retirement. The investor also has a risk tolerance (willingness to take risk) that is low (conservative). This low tolerance can infer a high allocation to fixed income assets. In this instance there is conflict between the ability to take on risk and the willingness to take on risk. Under these circumstances the client should be educated as to the risk return characteristics of various asset classes. In addition, the investor should also be shown that additional risk can be added to the portfolio given the sufficiently long time horizon as this should translate into higher returns for the client over time.