After nearly 30 years in the investment management industry I can say without hesitation that the thing that irks me most is the use of the word ‘risk’ and what it actually is. In my view it is the most misused and ‘glossed over’ of all the plethora of investment jargon that exists.
The word ‘risk’ is a bit like the word ‘love’. It has multiple meanings depending on who is using the word and in what context. You can love your dog; you can love your sister; you can love your child; you can love football; you can love your wife or husband. These uses of the word love all evoke different feelings and they each have a completely different connotation and context. And so it is with the word ‘risk’.
One of the better definitions of risk I have seen comes from Elroy Dimson, Emeritus Professor of Finance at the London Business School:
“Risk means more things can happen than will happen.”
In the superannuation investment industry people seem to talk about risk as though it means the same thing to all people. But it clearly does not. Risk is very different in the eyes of the client (the person with the superannuation account) versus the investment manager versus the regulator.
Let’s look at each.
The person with the superannuation account
My 24-year-old son has a superannuation account with a major industry fund. When I talk to him about risk and what matters concerning his account his answer is straight forward:
- when he contributed to the fund he wanted to know the money arrived safely (aka no one ran off with it)
- whenever he receives a statement he wants to be confident the information shown is correct (aka there is integrity in the underlying data systems)
- when he wants to access his money in future years he knows it will be there (aka the institution is credible and reliable and not a ‘fly by night’)
- the money is being competently invested
- the fees are fair (aka he is not being ripped off)
- if provided, the insurance will kick in if a relevant event occurs to him.
I’d also add on his behalf, since he’s unlikely to be focussing on this yet, will he have accumulated enough money at the end of his working life to live on?
In any case, there’s not much here on the standard industry definition of risk, the volatility of returns.
The investment manager
When managing a fund that many others are invested in (that is, a managed investments scheme) the investment manager is trying to invest in one way to suit the needs of many. However, he or she does not know the attributes, attitudes, timeframes and needs of the ‘many’ and so by necessity must manage the investments with one eye shut.
The investment manager thinks of risk in terms of the following:
- volatility of the value of an individual asset
- volatility of the valuation of an asset sector (usually based on history)
- concentration risk (having too few securities in a portfolio)
- differentiation from competitors
- differentiation from the benchmark being used to measure the performance of the fund.
And most investment managers measure the above things over quite short time periods, often less than a year, and indeed are usually remunerated based on ‘success’ over one year periods.
And then of course we have the regulator. Whilst I am sure the regulator thinks of risk very widely, it seems to me they want trustees to adhere to some of life’s basic rules:
- be honest and fair
- take your role seriously, both in the way you act and your knowledge and skill
- try your hardest
- if you make a mistake say sorry and rectify it
- don’t receive a personal benefit at the expense of your clients.
I have a short and simple book called Life’s Little Instruction Book, by H. Jackson Brown, which records personal observations from a father to his son to help him in his life. I sometimes wish our law-makers would use it and save paper!
So where are we going wrong on risk?
With these multiple facets to the word ‘risk’, where does this leave us?
I believe there is a high misallocation of resources, energy and intellect across the superannuation industry (and investment industry more broadly) to address risk. The media use the word risk in quite a sensationalist manner, often without proper definition and logical timeframe for measurement. And I believe regulators have a thirst to micro manage risk and even attempt to eliminate risk, as though this unquestionably gives a better outcome, and without proper regard to the cost and benefit of what they are seeking to achieve.
And most talk about risk in investment circles in a one dimensional manner, being the volatility of the value of an asset, when this is often meaningless without appropriate context.
Analysts report as though risk can be measured or adjusted with pin point accuracy, using phrases such as ‘too much risk’ and ‘risk-on, risk-off plays’, when this is simply not the case.
The wisdom of Howard Marks on risk
The best overall summary I have read on risk is contained in Chapter 5 of Howard Marks’ The Most Important Thing, Uncommon Sense for the Thoughtful Investor. Although many investors in Australia may not know of Marks, he is well known in the US investment industry and in my opinion he is up there in wisdom with Warren Buffet. Buffet himself said of this book, “This is that rarity, a useful book.”
Marks makes the point that according to the academicians (his word, not mine!) who developed capital markets theory, risk equals volatility, because volatility indicates the unreliability of an investment. Marks takes great issue with this definition of risk, as he doesn’t think volatility is the risk most investors care about. I agree. Like Marks, I think the possibility of permanent capital loss from owning an asset is at the heart of what investment risk is truly about, followed by the possibility of an unacceptably low return from holding a particular asset.
Marks believes much of risk is subjective, hidden and unquantifiable and is largely a matter of opinion. He makes the point that investment risk is largely invisible before the fact – except perhaps to people with unusual insight – and even after an investment has been exited. And in the following words he points out a profound paradox:
“Return alone – and especially return over short periods of time – says very little about the quality of investment decisions. Return has to be evaluated relative to the amount of risk taken to achieve it. And yet, risk cannot be measured. Certainly it cannot be gauged on the basis of what ‘everybody’ says at a moment in time. Risk can be judged only by sophisticated, experienced, second-level thinkers.”
Marks makes the obvious observation that in dealing with risk there are three steps: understanding it, recognising when it is high, and controlling it. I believe we have a long way to go in understanding risk, particularly which risks matter the most, which surely must be those that impact the end investor the most (like my 24-year-old son). And I believe we must all have a far better framework of thinking to decide which risks we should allocate time, cost and resources to minimise or eliminate, versus those risks we should simply accept.
What does a better risk framework need?
What do we need in this risk framework? Risk is primarily about losing money and not meeting a realistic financial goal that you set out to achieve. Volatility or standard deviation of returns is at best a side issue. It’s convenient because statistical calculations allow a number to be put on risk, but it’s not really what matters.
Short termism has created an obsession with volatility. It would be preferable to prohibit the publication on performance numbers with less than 12 months of data.
I believe the really important things for investors are as follows, and if these matter for the clients, then they should also be the focus for trustees and regulators:
- prevention of fraud, such as the use of an independent custodian
- credibility and reliability of the institution investing the money
- experience, competence and integrity of the people doing the investing
- understanding by clients of investment markets and alternative choices (ie education)
- diversification of investments and avoidance of asset concentration
The regulator should focus on making the system honest and fair, and ensure both its own staff and those in the industry have appropriate skills to meet their obligations.
We can employ the best market experts, compliance officers by the dozen, regulators from every government department imaginable, and have committee signoffs, board approvals and obey every regulation in the land. And then something like the GFC can hit a portfolio, or there can be an environmental disaster, or an act of terrorism, and the best risk management in the world will not prevent a loss of capital. Spread sheets and management reports create an over confidence that we can recognise and understand risks in advance.
As Howard Marks says, and I wholeheartedly agree, the possibility of a permanent capital loss from owning an asset is at the heart of what investment risk is truly about. And ultimately, I don’t think there’s much that can be done to wholly prevent these risks.