WHAT IS RISK, REALLY?
The finance sector generates hundreds of thousands of words on the subject of risk. Defining exactly what it is remains a key issue of debate.
When describing risk, our industry casts around terms like volatility of returns or standard deviation of returns, credit risk, inflation risk, liquidity risk and so on, many of which are meaningless to most investors.
Cutting through all of this jargon, a more useful way to think about risk could be that it is the possibility that an investment performs worse than expected.
We can go further. If your investments don’t perform as expected, this may mean you do not achieve your investment goals.
Goals are unique to each investor. They could be to have a nest-egg of a certain dollar value by retirement, or to have a portfolio that generates a certain income in retirement to supplement a pension.
These goals, or objectives as we often call them, are what matters most for investors. If they don’t hit these objectives it can have serious implications for their lifestyle. They may have to save more or work longer before they can retire, or forgo the annual cruise because their retirement income is lower than expected or because their capital is eroding faster than expected.
Risk then, for investors, could be defined as ‘the possibility of not meeting your investment goals’.
In a research note from August last year 1, fund manager GMO came to a similar conclusion. To paraphrase GMO, “risk is not just the ‘standard deviation’ or volatility of returns. Risk is much more personal. Ultimately, risk is the possibility that an investor may not get the returns they need to meet their investment goals.”
Measuring risk – looking at variability of returns
When you look at risk through the lens of achieving goals, sometimes a portfolio that may look low risk, i.e. it could be invested only in bank deposits, could prove to be high risk if interest rates decline more than expected, and an investor is reliant on that interest income to fund their retirement, or to keep ahead of inflation.
At the other end of the spectrum, growth assets like shares and property offer higher potential returns, but are also more volatile and returns are less certain. Investors need to factor both the potential level, and the variability, of returns into their planning.
The chart below shows the five-year range of returns experienced on three portfolios since 1993, a lower risk Conservative Portfolio, a Balanced Portfolio and a higher-risk High Growth Portfolio. Also shown are the expected average returns for each.
As can be seen, the High Growth Portfolio offers a higher potential return than the other two, but this return is much more volatile.
The High Growth Portfolio’s returns have ranged from -1.7% to 16.9%pa over five-year periods while the Conservative Portfolio’s five-year returns have been much more stable, ranging between 3.7% and 8.1%pa. The Balanced Portfolio sits between these extremes with a range of 1.0% to 12.5%pa.
Accepting our argument that risk is the possibility of not meeting your goals, the first step to managing risk is to define your goals. You cannot manage risk if you do not have clearly defined investment objectives.
Your adviser can help you with this process. Focus on issues such as what income do you need in retirement and for how long, or how much do you need to save for your retirement, or how do you wish to protect the real value of your capital for the long-term so it has today’s buying power in 30 years time, and so on.
Once your objectives are clear, ascertain the return required to meet these goals, consider how reliable this return is, the possible range of returns, and assess what risk there is that you will not meet your objectives. This is the essence of risk management.
1 Who ate Joe’s retirement money?, Peter Chiappinelli and Ram Thirukkonda, GMO White Paper, August 2015.