Risk is a relative concept, like many things relating to human perception. In the very short run, the next few seconds say, there is negligible risk to your well-being while at the other extreme, as Keynes pointed out: “in the long run we are all dead.” It is the in-between where we have pretty much limitless choice.
Often subconsciously, we make choices about risk all the time. When we drive to work we take a substantially greater risk than we would if we stayed at home in bed. We do it because we need to earn a living and because we do not want to be bored. The risk is acceptable for the likely return. The low risk achieved by doing nothing is not a price worth paying. It is the same with investment. Although we can avoid the risk of loss by holding cash, it has proved over the long run to be not a price worth paying. The risk of being poor in your retirement as a result of your passive investment strategy is high. Consequently, the risk of loss needs to be downgraded as a priority and the avoidance of the risk of low returns needs to be promoted.
It is fairly intuitive and most people would understand the “speculate to accumulate” concept. It is also reasonably obvious that investment classes such as equities and property grow faster than cash in the long run. Which asset class would you have rather invested in in 1800? Certainly not cash and probably not government bonds
– in hindsight, equities and property would have been the best choices by a country mile. However, requirements of investors differ – one person may want income and believe that what happens to their capital does not matter as long as the income is certain and for long enough – an annuity would be a good example of this approach. For others it is the opposite – the capital is all-important and the income does not matter.
Many family offices will have clients of a further sort: “this money has been in my family for eight generations – I am not the one who is going to lose it.” For this investor, capital preservation plus, say 3%, is a lot more important than accepting some risk of loss for a potential gain of, say, 10%. Others may wish simply to do as well as their peers, or have enough in retirement and need to take relatively high risk to achieve that. Overlaying all this is the investor’s time horizon – does the goal need to be achieved quickly or over a long period of time?
Having identified investors should take account of risk in their investment strategy then it probably makes sense to identify the different amounts of risk they may want
to take and treat them differently for the purpose of investment. The development of portfolio theory by Markowitz and Sharpe in the 50s and 60s advanced the idea that
a set of investments with differing risks and performance cycles matched together can, by definition, be more efficient than investing the whole portfolio in a single instrument. The idea that for any set of investments at a given risk level, there
is an optimum mix of those investments is the so-called “efficient frontier.”
Economist James Tobin took a slightly different view, which introduced elements of behavioural finance. This was the idea of risk buckets. In the simplest example, you would have one bucket of low risk investments servicing immediate needs (everyday living) and another bucket of higher risk investments where the investor would take higher risks over a longer period of time for spending in the future, ie, income in retirement.
In order to understand the risk of a portfolio as described above, one needs to understand the volatility of the instruments contained within it. This is relatively easily understood and the annualised standard deviation is an accepted and common measure that enables at the instrument level, simple comparison.
Having said that, it is still easy to make a pigs ear of comparing and contrasting the risk of individual investments. Note the attempt by the European Union and its internal market commissioners’ eminent Committee of European Securities Regulators (now called the European Securities & Markets Authority (ESMA)) and its attempt to clarify for investors the risks of investing in UCITS funds. They have mandated that part of the new two-page Key Investor Information Document (KIID) should show the Synthetic Risk & Reward Indicator (SRRI). This is worked out by reference to annualised volatility.
Unfortunately the academic input they have had in calibrating the volatility intervals
of their seven risk classes has been so dry and ivory tower-like that the practical application of these risk measures in the places like UK will be muted. For example, the volatility intervals of risk class one are between 0% and 0.5% and for risk class two, between 0.5% and 2%. In practice there are very few funds that fall into either of these two risk levels. The majority of all funds are in risk levels four, five and
six. Equally, there are virtually no funds in risk level seven, which is a whopping 25% annualised standard deviation.
The bunching that this sort of calibration creates is unhelpful and as a result it is unlikely that many investment analysts or planners who are seeking to differentiate funds by their risk score will use SRRIs.
However, there are very few risk scoring systems around for financial planners to rely upon. Distribution Technology has one for the unit trust and OEIC universe
in the UK. FE has one relative to market movements, as opposed to the absolute system used by the EU’s KIID with its attendant disadvantages mentioned above.
Some individual fund providers have risk bucketed or risk targeted portfolios like Fidelity’s target funds or Skandia’s Spectrum ranges. Skandia has 10 fund of funds in its range, targeted at different risk levels. Fidelity takes a different approach, allowing investors to choose a ‘target date’ in the future when they estimate the investor will require the cash, reducing the risk of the fund progressively as the target date approaches. Either way, both groups are using a risk scoring system to calibrate both the instruments and the portfolio.
Assuming one can find and use a sensible risk scoring system at the instrument level, one can then apply that in the context of portfolios for oneself. Using individual risk scores in this way, the benefits of diversification can be seen.
In the table above, in Portfolio A the funds are well correlated as they are all doing the same thing (investing in European smaller companies), so the benefits of diversification are small. In Portfolio B, the constituents are much less well correlated, so the benefits of diversification are much greater.
Thus you can see that by making sure the portfolio constituents are non-correlated, one can achieve a lower portfolio risk while leaving the constituents at the same risk, or for the same portfolio risk, one can increase the risk of the constituents (therefore maximising the gains that can be achieved) while holding the portfolio risk constant. These gains cost nothing – just some Risk Scores and a well-adjusted optimiser.
Clients’ risk needs differ and as such they should be provided with the choice of different risk ‘buckets.’ Putting several instruments into a portfolio bucket (at least more than one), enables one to optimise for the lowest portfolio risk while using the riskiest funds, at any particular overall portfolio risk level. In other words, by using risks scores and a specialised optimiser, one can create really efficient portfolios at a series of given risk levels (or buckets).
