Docstoc

THE MEANING OF RISK

Document Sample
THE MEANING OF RISK Powered By Docstoc
					T H E I N TA N G I B L E E L E M E N T O F I N V E S T M E N T M A N A G E M E N T




THE MEANING OF RISK




Risk is a little word for a very big subject. However,                Furthermore, it is not a definition of risk that can be
broadly speaking, an investor faces two main types of                 applied to all forms of investment equally. For
risk - counterparty risk and investment risk. In turn,                example, there is little risk of the UK Government
investment risk needs to be considered over different                 failing to honour its obligations in the gilt-edged
timeframes and from both a real and absolute                          market, but gilts can be highly volatile in price so they
standpoint.                                                           certainly involve some form of risk.

Counterparty risk is the risk of failure on the part of               Against this background, it is common practice to
the bank, stockbroker or investment manager who                       define risk as the volatility of return from an
conducts transactions for the investor and may also                   investment as measured by the Standard Deviation of
hold the investor’s securities and cash balances.                     its return over time.

There are several levels of investor protection in place.             Standard deviation is an arithmetical measure of
For example, custodians hold clients’ assets to the                   variability. The wider and more variable the range of
clients’ order rather than their own, so the assets are               the returns that an investment displays is over time,
ring-fenced and the clients are protected in the event                the greater its inherent risk as evidenced      by the
of the custodian failing. Auditors and regulators                     higher standard deviation of its return. Similarly, the
exercise close supervision over the whole financial                   lower the standard deviation, the lower the inherent
services sector and there are compensation schemes                    risk.
in place.
                                                                      By way of illustration, Table 28.1 shows the price
However, disasters can still occur and the best                       behaviour of a highly volatile investment ‘A’ and
protection for the investor is to limit dealings to firms             Table 28.2 shows the price behaviour of a low-
of the highest quality, standing and credit-worthiness.               volatility investment ‘B’.
Most financial institutions now devote more effort
than ever before to assessing the strength of their                   It is only necessary to glance at these diagrams for a
counterparties and keeping their arrangements under                   moment to realise which of these two securities the
review.                                                               investor is more likely to misjudge when making
                                                                      buying and selling decisions. Investment ‘A’ clearly
Investment risk is the risk that is inherent in the                   provides more opportunity for error since its price
investments themselves. In one sense, investment risk                 moves more frequently and by a greater amount than
means the danger of a particular asset within an                      that of investment ‘B’. Standard deviation is simply
investor’s portfolio failing and it becoming worthless.               an expression of the frequency and amplitude of these
However, this is a narrow definition of risk since it                 oscillations.
deals only with the extreme form of risk and, if the
investor wishes, risk of this nature can be reduced by                In other words, Standard Deviation is no more than
diversification to the point where any one single asset               a mathematical expression of a common sense
failing does not really matter.                                       observation. Common sense suggests that shares are
                                                                      more volatile and therefore riskier than gilts, whilst
If one holds, say, just six equity investments of equal               both are riskier than cash on deposit. However, using
value, the failure of one of them requires the other                  standard deviation, it becomes possible to quantify
five to each rise by 20% to restore the value of the                  this difference in risk and relate it in a scientific way
portfolio. If one holds, say, fifty investments of equal              to the returns that these and other forms of
value, the other forty-nine need only rise by 2% each                 investment offer.
to restore the position to the day before the
“disaster.”




154
The meaning of risk




                                                               28.1
How does volatility create risk? In a falling market,          Investment “A”
it creates the risk of having to sell at a bad time, it
creates the worry which keeps some investors awake              30
                                                                                                                                      Price trend
at night, it creates the fear of another crash every time
markets are weak and it creates the temptation to sell          25
out in despair at the bottom. In rising markets, it
creates the temptation to sell prematurely, it creates          20
the temptation to invest in ever more speculative
holdings, it creates the temptation to borrow in order          15
to invest more and it creates the frustration of            Price
accepting opportunity cost when inherently poor                 10
investments seem to prosper in the short term.
                                                                                                                        Actual price
                                                                    5
In short, volatility stimulates the emotions of fear and
greed that magnify risk by distorting the investor’s                0
judgement. This aspect of investment is discussed in                    1       2       3       4   5   6     7     8        9        10   11   12
more detail on page 164 in the chapter dealing with                                                         Time
                                                               Source: Sarasin & Partners LLP
The Psychology of Investment.

Market participants must be paid for assuming these            28.2
risks or else the whole system of financing business           Investment “B”
would break down. Therefore, equities must provide
a long-term return that is significantly higher than the        30
risk-free return available by simply leaving money in
the bank. Similarly, investors in gilts expect to earn a        25
higher return than cash on deposit since the                                                                Price trend

Government will not be repaying the money for many              20
years and there is a risk that what is an attractive
interest rate today may not prove as attractive later on.       15
                                                            Price




                                                                10
                                                                                                            Actual price

                                                                    5


                                                                    0
                                                                        1   2       3       4   5   6   7     8 9       10       11    12 13 14
                                                                                                            Time
                                                               Source: Sarasin & Partners LLP




                                                                                                                                                155
T H E I N TA N G I B L E E L E M E N T O F I N V E S T M E N T M A N A G E M E N T




                                                                                  28.3
Table 28.3 plots the quarterly risk and return                                    Unit Trust / OEIC Volatility (%)
characteristics of cash on deposit, UK equities,
conventional gilts, index-linked gilts and overseas
                                                                                                  15
equities since 1982 - the longest period during which
                                                                                                  14
all these instruments have been available to investors.                                           13




                                                                     Return - Average annual return
Overseas investment was subject to exchange controls                                              12
until 1979 and index-linked gilts were only made                                                  11
generally available to investors in 1982.                                                         10
                                                                                                   9
                                                                                                   8
It will be seen that, as suggested earlier and as                                                  7                                     Index linked gilts
common sense indicates, shares are more volatile and                                               6
                                                                                                                                         FTA All Share
therefore riskier than gilts, whilst both are riskier than                                         5
                                                                                                   4                                     Cash
cash on deposit. Overseas equity investment is the                                                                                       Overseas equities
                                                                                                   3
most volatile of all since there is currency risk as well                                          2                                     Conventional gilts
as underlying stock market risk.                                                                   1
                                                                                                   0
                                                                                                       0                5            10 15                    20
It can also be seen that, in recognition of this greater                                                   Risk - Standard deviation of annual returns
element of risk, conventional gilts have provided
higher returns than cash on deposit and UK equities                               Source: Sarasin & Partners LLP

have provided higher returns than both. On the other
hand, non-UK equities have involved the most risk                                 The standard deviation of a portfolio’s return can
but have not provided extra return to compensate -                                readily be calculated in such a way that its risk and
they have given lower returns than UK equities yet                                return characteristics can be compared with those of
involved more risk.                                                               other portfolios or compared with the risk and return
                                                                                  characteristics of the main stock market indices over
It is also interesting to note that index-linked gilts                            the same period. Standard deviation is supplied as a
have provided the lowest return despite involving                                 pre-programmed function in most spreadsheets.
significantly more risk than cash on deposit. This is
partly because cash on deposit earned an unusually                                The more readings used, the better the quality of the
high real interest rate over much of this period.                                 message that will emerge, but five years of quarterly
                                                                                  readings will generally start to provide a fairly clear
The practical significance of this is that, in the same                           signal, or three years of monthly reading.
way that standard deviation can be used to assess the
risk and return characteristics of individual                                     As an illustration of the way in which this
investments or asset categories, it can also be used to                           methodology can be applied to real portfolios, league
assess the performance of an investment portfolio to                              tables of unit and investment trust performances now
see if the return adequately compensates for the                                  commonly include a measure of volatility alongside
degree of risk taken.                                                             the raw performance data. Table 28.4 shows the way
                                                                                  in which the volatility of unit trust performance varies
By way of illustration, if two portfolios have each                               in light of the nature of their underlying investments.
given a return of 20% per annum then, on the face of
it, both returns are equally satisfactory. However, if                            Here again, the measure of volatility bears out
portfolio ‘A’ had at first doubled in value and then                              common sense judgement - money market trusts are
fallen back sharply to give the overall 20% return,                               the least volatile, whilst emerging markets and Far
whereas portfolio ‘B’ had compounded gradually at a                               East trusts are the most volatile, with everything else
consistent 4% to 5% a quarter to reach the 20%                                    on a rising level of volatility in between.
return, the latter would represent the better quality
return since it would have been achieved with less risk.


156
The meaning of risk




28.4                                                        28.5
Unit Trust / OEIC Volatility                                Asset Mixes and Headline Statistics

                                                3-Year                                                Model
                                               Volatility                                      A       B           C
Average UK Money Market Fund                        0.5                        Bond          85%    50%          15%
Average UK Bond Fund                                6.0                        Equity        15%    50%          85%
Average UK Equity & Bond Income Fund               10.1
Average UK Equity Fund                             18.2     Expected Return                  5.0%   6.2%        7.3%
                                                            Yield                            4.7%   4.0%        3.3%
Average Japanese Equity Fund                       17.7
Average European Equity Fund                       22.8     Standard Deviation               5.6%   8.5%       13.3%
Average North American Equity Fund                 18.5     Value At Risk                    3.3%   5.3%        8.8%
Average Asia Pacific (ex-Japan) Equity Fund        25.4
Average Emerging Markets Equity Fund               27.5
                                                            Source: Sarasin & Partners LLP

Source: Reuters Hindsight




This chapter has set out to address risk by                 It can be seen that as the equity content increases, the
concentrating on volatility since this is the most          expected return increases from 5% per annum to
commonly used definition. However, it is also one of        7.3% per annum. However, the yield reduces as the
the less sophisticated measures and beyond standard         weighting in bonds decreases. There is also a
deviation there are a number of more complicated            corresponding increase in the risk. This is shown by
risk measurement tools.                                     the increase in Standard Deviation, and VaR statistics,
                                                            where the greatest loss one might expect to suffer in
For example, the concept of ‘beta’ relates to the           normal market conditions with the bond-oriented
sensitivity of the price movements of individual            fund is 3.3%, while there is a risk of the equity-
securities or portfolios to movements in the market         oriented portfolio falling in value by 8.8% in a single
as a whole. The concept of ‘tracking error’ measures        quarter.
the volatility of a portfolio’s return relative to an
index or benchmark. The concept of ‘Sharpe Ratio’           The result of modelling like this can go a long way to
recognises that risk is a good thing if rewarded            helping investors decide what asset mix suits their
properly, by measuring the ratio of the return from a       particular investment objectives. Taken to the
security to its volatility. The concept of ‘information     extreme, it is possible to create an efficient risk/return
ratio’ does this for whole portfolios.                      frontier made up of a series of portfolios that weight
                                                            a very wide variety of assets in different proportions.
‘Value at Risk’ measures the maximum likely loss that       Technically, all that investors then need to do is
any given portfolio is likely to incur in normal market     choose the portfolio whose risk/return characteristics
conditions. This can be a particularly useful concept       most suit their underlying investment objective.
for the charity trustee looking to gain a feel for the
maximum capital loss their portfolio might suffer.          However, a word of warning! Tables and charts like
                                                            this tend to over-simplify a very complicated subject.
By using historic returns from a variety of asset           Measuring the historic investment returns from a
classes, and mixing them together in different              range of asset classes and predicting future returns in
proportions, one can show the key risk characteristics      the light of economic and market forces is one thing.
of different model portfolios. Table 28.5 looks at          Factoring risk into models is another and the
three possible asset mixes and notes the headline           compound effect of combining so much data, much
statistics that would be associated with them.              of which calls for a high degree of subjective
                                                            judgement, means that the output is rarely free from
                                                            debate.



                                                                                                                  157
T H E I N TA N G I B L E E L E M E N T O F I N V E S T M E N T M A N A G E M E N T




                                                                             28.6
                                                                             Efficient Frontiers: Mixed Bond and Equity Portfolios
                                                                             (%)            1
                                                                                           1 year volatility absolute
                                                                            10
                                                                                                                                      100% Equities
                                                                              9
                                                                              8
                                                                              7
This is illustrated by tables 28.6 to 28.8. Table 28.6
                                                                                                              50% Bonds




                                                                     Return
                                                                              6
is a commonly used analysis of the risk and return                                                            50% Equities
                                                                              5
impact of mixing two asset classes together, in this                                   100% Bonds
case UK government bonds and UK equities. It can be                           4

seen that as the proportion of equities increases, so                         3

does the risk. This is used to show how much riskier                          2

equities are than bonds.                                                      1
                                                                                                                     Risk
                                                                              0
                                                                                  10        12          14            16         18        20        22
However, this well-travelled diagram is actually
                                                                             Source: Sarasin & Partners LLP                  D
misleading unless one is contemplating a 12 month
investment. Investors who have a timeframe
stretching beyond a single year should consider the
                                                                             28.7
volatility of the assets over periods longer than just a
                                                                             Efficient Frontiers: Mixed Bond and Equity Portfolios
12 month timeframe.                                                          Taking Account of Inflation
                                                                              (%)                    11 year volatility real
Longer-term investors should also consider inflation.
                                                                        10
Table 28.7 shows the 1 year data but this time in                                        Real
                                                                             9
“real” terms. It can be seen that the overall level of                                   Absolute
                                                                             8
returns drops. Interestingly, while the volatility of real                                                                            100% Equities
                                                                             7
equity returns reduces, the volatility of bond returns
                                                                    Return




                                                                             6
increases.
                                                                             5
                                                                             4
Table 28.8 re-draws the line after taking account of                                  100% Bonds
                                                                             3
different periods of investment. It can be seen that as
                                                                             2
the holding period increases, the volatility of real
                                                                             1
equity returns reduces much more quickly than                                                                        Risk
bonds. This would suggest that, for the longer term                          0
                                                                                 10         12         14             16         18     20          22
investor, equities don’t just produce better returns
                                                                             Source: Sarasin & Partners LLP                  D
than gilts, but they do so with a lower degree of risk.

Ultimately, risk is a wild and unpredictable beast!
                                                                             28.8
It would not be worthy of the name otherwise and the
                                                                             Longer-Term Efficient Frontier Studies Real Returns
debate as to whether investment is an art or a science
                                                                              (%)           MMultiple year volatility
will never be resolved satisfactorily.
                                                                            6.0
                                                                            5.5
                                                                            5.0
                                                                            4.5
                                                                                                                                                25 year
                                                                   Return




                                                                            4.0
                                                                                                                                                15 year
                                                                            3.5
                                                                                                                                                5 year
                                                                            3.0
                                                                                                                                                3 year
                                                                            2.5
                                                                                                                                                1 year
                                                                            2.0
                                                                            1.5
                                                                            1.0
                                                                                   0             5              10    Risk 15         20                 25

                                                                             Source: Sarasin & Partners LLP




158

				
DOCUMENT INFO