Three Things An Investor Should Know About Risk

By: Tim Bennett
Tim Bennett addresses three common misconceptions about one of investing’s most important words.

In this short article we take a look at risk and try to deal with some common misconceptions that can lead investors astray. Here they are in summary before we break each one down in a bit more detail;

  • Managing risk matters as much as seeking returns
  • Risk cannot all be quantified
  • Taking on more risk does not guarantee better returns

Some thoughts on managing risk

“If we avoid the losers, the winners take care of themselves” are the wise words of Howard Marks, CEO at Oaktree Capital. In a low yield environment in particular investors can be tempted into taking on too much risk as they chase returns. Without going into a vast topic in detail here, investors should bear in mind three key principles when it comes to risk management;

  1. Low purchase prices are not in themselves a guarantee of returns but they do increase your potential upside whilst limiting your possible downside. The father of value investing, Ben Graham, noted that buy good stocks isn’t enough – you also need to get them at a good price. The trick is to build a margin of safety into the price that allows you ride out periods of underperformance and tricky market conditions
  2. When there is nothing worth doing, don’t try to be too clever. Ex-US President Ronald Reagan once quipped to an aide “Don’t do something, just stand there”. Investors should sometimes take heed. Once you have established a well-balanced, diversified portfolio according to your chosen strategy, don’t tinker with it until and unless circumstances change. Equally if there are no attractively priced stocks out there, don’t force yourself to buy any – just be patient and wait for an entry point that you feel comfortable with
  3. You must be able to survive the market’s worst days and not just its average ones. In order to commit to time in the market make sure your portfolio can withstand an occasional battering and that you have sufficient liquidity to see you through a bad patch. Apply this thought process to anyone you entrust your money to as well – look at a fund manager’s performance history in bad, as well as good, times and check the maximum drops in their fund values rather than just focusing on how they deliver when things are going well

Be wary of magic numbers

A whole army of rocket scientists work in and around financial services employed largely to quantify and analyse risk. As a result you will come across metrics at every turn that claim to offer the best snapshot on it – standard deviation, beta, Sharpe ratios, delta and gamma are just a handful of examples.

The problem is that whilst these all have their place in investing, none of them captures behavioural risk, which US billionaire investor, Warren Buffett, summed up as the uncanny knack some investors have of making investing risky simply through their own poor behaviour.

We have covered some of the following examples of this in more detail elsewhere so here is a very quick summary of some of the more common behavioural errors;

  • Market timing (tempting, but almost impossible to achieve consistently)
  • Anchoring (getting stuck on irrelevant, historic data or becoming overly wedded to an investment approach that no longer works or a security that no longer delivers)
  • Herding (following the crowd and performance-chasing, such that you end up buying high and selling low more often than the opposite)
  • Overconfidence (confusing luck with judgement, which can lead an investor to abandon a carefully planned strategy and pile too heavily into one particular sector or stock)

The risk and return relationship is not linear

Novice investors in particular are prone to think that the relationship between risk and return is simple – you take more of the former to get more of the latter. This is far from the whole story. The following diagram exposes the problem – the graph on the left portrays the simple, linear way some investors think the risk/return relationship works. The graph on the right reveals the truer picture.

This is a vast topic, on which much has been written outside of this short article, but in summary, investors must grasp that;

  • As you take more investment risk, expected returns should rise but actual returns may not
  • The range of possible outcomes increases as you take more risk
  • This means that the best outcome gets better but the worst also gets worse – indeed the chances of the worst outcome being negative rise with risk

Armed with that simple understanding, an investor will approach risk differently – yes, you want to generate the maximum “bang per buck” of additional risk but at the same time you must fully understand the likely pattern of future returns and your potential downside.

To find out more about understanding and managing risk in the context of your portfolio, please speak to your Investment Manager.