Wma journal summer 2015 the management of risk small

Issue 2 • summer 2014

WMA JOURNAL Working for the Investment Community & their Clients

RISK

The management of risk Risk is a complex subject. It is not easy to measure. The regulators have shied away from laying down criteria on what constitutes varying levels of risk, let alone setting benchmarks by which risk can be measured. However, it is important to define what is meant by risk in the context of investing, as the client is effectively paying for the management of an agreed level of risk.

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ash, for example, is not risk-free. A 5% return on a building society account with inflation at, say 2%, gives a real rate of return of 3%. However, if the rate falls to 4% the real rate of return falls by one third if inflation remains the same. Cash carries a risk.

Risk is therefore the chance that expectations won’t be realised, and I use stock market returns as an example. The variability of stock market returns over past years provides a guide to how frequently expectations may not have been met. The greater the variability (deviation) of past returns the more frequent the disappointment. For example, the annual mean real return and standard deviation for equities, gilts and cash for the UK in the period 1900-1999 is shown in the chart below.

This shows that historically equity returns are riskier than gilts, which are riskier than cash.

But the higher the risk, the greater the potential return. If shorter periods are chosen, the result is similar – over any reasonable period of time – five to ten years is usually accepted by the financial fraternity as ‘reasonable’ – equities have given a higher rate of return than gilts or cash, but for a higher risk of prices falling in the shorter term. So an investor has to make a trade-off between risk and return. This is the reason why a total growth strategy is risky if there is an income requirement. The need for income means that if there is a short term drop

in the market the investments cannot be held for the required period to allow them to recover and therefore the risk is much higher.

The risk of investing in an individual equity is magnified to the extent that many factors can affect its performance. There are spectacular instances where companies which have been regarded by investors as ‘low risk’ have failed.

However, this risk can be substantially reduced by diversification. For example, a portfolio consisting of just one stock – an ice cream manufacturer – would constitute high risk, as bad weather would mean a loss. However, if the portfolio was equally invested between the ice cream manufacturer and an umbrella manufacturer, it would be of lower risk, as, whatever the weather conditions, a loss on one could be cancelled by a gain on the other.

Lowering the risk in an equity portfolio is therefore achieved by diversification.

Thus, although investment risk can be reduced by constructing a diversified portfolio it cannot be eliminated. A diversified equity portfolio will still be subject to movement in the economy, political factors, raw material price movements, and so on. A diversified equity portfolio is likely to exhibit the characteristics described above – higher than average returns compared with Gilts and cash over a period of time, but subject to greater volatility of return over a shorter time horizon. The longer the time period, the greater the likelihood there is of out-performance – the shorter the time period (historically up to around five years) the greater the chance of under-performance.

Thus, these are the key determinants in setting an investor’s risk profile, and the risk level in a portfolio that the investor is prepared to accept is inextricably linked to the investor’s time horizon. The greater the need for the investor not to be disappointed in terms of performance in a given time-frame, the lower

Annual mean return

Equities 7.8

Standard deviation 20.1

Gilts 2.2 14.6 Cash (Source – Dimson et al 2000) www.thewma.co.uk

1.2

6.6

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Although investment risk can be reduced by constructing a diversified portfolio it cannot be eliminated the risk profile needed from the portfolio. An investor who is entirely dependent on his portfolio for producing the wherewithal to live on for the rest of his life must take a low risk approach, with a higher certainty of generating the income required at the expense of the chance of stronger capital growth. In this situation, the risk-averse investor will sacrifice future potential growth for the certainty of asset protection and predictable income.

Thus, in an equity/Gilts/cash context the portfolio would be heavily weighted towards Gilts and possibly quality corporate fixed interest, with a small equity content to provide some longer term protection from inflation. An investor with the certainty of a future asset/ income stream within a reasonable timescale (as in someone able to draw on a pension fund) could afford to have a higher equity content as long as the income requirements were largely met, and that there was not an over-dependence on equity performance to make up any shortfall.

The above description covers all aspects of portfolio management, but the theme is the same. The investments – whether they are in shares, structured products, insurance products, or any other form of investments – must be suited to the risk profile of the client.

Diversification is essential in order to minimise risk within the portfolio. The more averse the client is to the risk of losing money, the greater the concentration there has to be in Gilts or even cash, as long as the client recognises that neither are likely to provide significant real rates of return over a long period.

Mike Jones Chairman, MBA Systems WMA JOURNAL

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