Risk management
It's a frequently used buzzword in financial circles, but what does the term 'risk' really mean when it comes to investment? Editor Heather Farmbrough explains…
Risk is a word that often carries negative connotations but, in investment, risk can actually be a good thing. The notion of risk and return is central to investment.
Equity investors take a risk by putting their cash into stocks and shares in the expectation that they will outperform the returns on cash in the bank or in gilt-edged stocks. They risk losing their money or perhaps missing out by not investing it elsewhere if the returns are better. The man who keeps his cash under the bed because he doesn't want to risk losing it on the stock market, on the other hand, risks being burgled and losing it all - or missing out if shares go up. It's a question of which risk he would rather take.
For most investors, there is a tacit understanding that investment carries a degree of risk in the hope of superior returns - what matters is to take on the appropriate level of risk. Measuring risk is now a highly sophisticated aspect of investment analysis and there are complex technical asset pricing models constructed to show possible scenarios. But risk means different things to different people.
A pension fund trustee may look at risk differently from an active investment manager - that is, one trying to outperform a particular index or benchmark by taking 'positions' (not investing proportionately to the index) in assets or shares that he or she expects to outperform that benchmark.
Relative Risk
Pension fund trustees are keen to avoid too much volatility in the performance of their equity funds and so measure the probability that the fund's investment performance will differ from the index or benchmark. The difference between the portfolio and the benchmark return will come from the difference in amounts invested in a stock held in the portfolio compared with the amount which is held in the benchmark. From their perspective, the more the amount invested in the portfolio differs from the amount in the index, the greater the risk becomes that performance will differ from the index by outperforming or underperforming.
Some active fund managers, such as investment trust or OEIC managers, take a risk by investing in a non-index portfolio, in the expectation that they will be able to select better performing stocks and therefore outperform - the skill here lies purely in their selection of stocks.
Risk in the benchmark
Investors sometimes buy tracker funds, which track an index - but these are not necessarily less risky. The large companies that make up major indices, such as the FTSE 100, are those that have performed well in the past - but there is no guarantee they will continue to do so (see Trust Issue Seven, 'The Power of London'). As James Anderson, Baillie Gifford's chief investment officer, says: "Sometimes the risk is in the index, with the associated danger that the index itself performs badly." This was the case in the FTSE 100 between 1999 and 2000, when it held a number of overvalued technology and communications stocks prior to the 2000 technology crash.
Anderson also says that FTSE 100 stocks are often perceived as safe when they can actually be riskier. Shares in BP and Shell, for example, have performed less well recently than those in Russian oil giant Gazprom, which some people would consider riskier, especially as it is run in an environment (or country) believed to be less politically stable and in an emerging market. It all comes down to the investor's point of view; Anderson assesses the risk of losing out by not holding Gazprom as higher than the risk of investing in the company.
Rise of the unknown
Modern risk analysis relies heavily on building in specific risks to a sophisticated model so as to assess the probability of a particular outcome. But some risks cannot be foreseen. For example, there is what investment gurus describe as 'event' risk - that is, a major, unpredictable catastrophe, such as a natural disaster, war or act of terrorism, which is capable of suddenly shaking markets. Or, as James Anderson has defined it: "Risk is precisely what we don't know. Risk is the unknown."
What is the solution? One response would be to think about what might happen - such as, how the portfolio would react to a rise in the price of oil, a hike in interest rates or a currency rising sharply, and to make sure that the portfolio is constructed rigorously enough to be able to deal with any of these scenarios.
Spreading risk by diversifying a portfolio has become elementary investment practice - the 'don't put all your eggs in one basket' theory. So how many shares does a portfolio need in order to be considered diverse?
"You need a certain number of shares to ensure that you're not riding on one horse, but you also want to be in a position where each of the individual stocks will have an impact on performance," explains SAINTS manager Patrick Edwardson. "Empirical evidence has suggested that if you have 40 or so stocks, then the majority of the diversification is done and, after that, there is not a great deal of incremental gain."
Fundamental risk
It is also important to remember to keep fundamental risk - that is, poor analysis of the fundamentals such as the balance sheet or company statements - as low as possible by making sure that the analysis on which decisions to buy or sell shares are based is as detailed and rigorous as possible.
The most pragmatic approach for equity investors to follow is to try to reduce the risk element where possible by sticking to companies which are financially strong and will generate cash, and those which are able to demonstrate sustained earnings growth.
There is no doubt that the term 'risk' has many definitions, but it can be a positive force, since it creates chances for reward. Good investors can and do take risks. Providing that it is managed carefully and effectively, risk can actually be good news for investors.
Investment markets, including currency exchange rates, can go down as well as up and market conditions can change rapidly. The value of your investment and any income from it can fall as well as rise and you may not get back the amount invested. The views given should not be taken as fact and no reliance should be placed on these when making decisions about investment.
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