Risky Business: Understanding Investment risk

“Risk” is a multi-faceted concept that has come under increased regulatory scrutiny in recent years. That is not to say that risk is bad; however, it must be managed in a manner that fits an investor’s capacity for loss.

Elizabeth Savage

By Elizabeth Savage, Research Director.
Elizabeth Savage explains why it is more important to understand investment risk than avoid it altogether.

Much of the rhetoric around risk is still confined to volatility, but it is broader than that because even low volatility can mask a number of threats to your returns. These can include liquidity risk, default risk, mark-to-model risk, and the susceptibility of some asset classes to larger drawdowns than others.

It is also important to remember that none of the risk measures under discussion are perfect, nor can they exist in isolation. They all rely on backward-looking data, which is why it is important to use top-down macro analysis – or look at how global events could affect assets – to understand the dynamics in which they operate, what may change, and when.

Volatility

Volatility is all about its interpretation. Low volatility does not necessarily mean low risk; conversely, high volatility isn’t necessarily bad.Volatility describes the distribution of returns around the mean (or average) return, over equal periods (such as from month to month). In other words, it measures the extent to which prices change. For example, when looking at the distribution of returns for UK equities between 2008 and 2013, returns tend to lie within a tight range around the mean for approximately two thirds of the time (0.4 per cent).

Volatility, therefore, tends to assume a normal distribution of returns and does not account for extreme returns or “fat tails”. Neither does volatility differentiate between “good” volatility (returns above the mean) nor “bad” volatility (returns below the mean). Investors can also easily assume that portfolio risk is the sum of the constituent asset volatilities – it is not.

Using correlation

Diversification is the only free lunch.
We use correlation to find these diversifying assets. Correlation quantifies the strength and direction of the relationship between two assets. In other words, it is the relationship between them and their movements.
Correlation ranges between -1 to +1 (a figure of 0 implies no correlation). The number gives us the strength of the correlation, and the positive or negative reveals the direction. So, if two asset classes have a perfect positive correlation of +1, as one of them moves either up or down, the other will move in tandem and in the same direction. Alternatively, a negative correlation means that if one asset class moves in one direction, the other will move in the opposite direction.

An asset that is less correlated can provide diversification benefits, even if it is positively correlated. Importantly, correlations change over time and they need to be monitored. At the end of 2011, for example, gold demonstrated a high correlation to equities and lost its safe-haven status.

The focus on correlation is, therefore, key to managing risk. To help us do this, we divide assets into proprietary buckets: liquidity, equity risk and diversifiers (LED). Within liquidity, we segregate assets with low-price volatility, low credit risk and low duration risk, such as cash, government bonds and high-quality investment grade debt. In the equity risk bucket, we include equities and all assets that are highly correlated with equities, such as corporate bonds, property equities, and commodities that are sensitive to the economic cycle.

Finally, within the diversifiers, we categorise assets with diversification potential, demonstrated by a low correlation to equities – for example, total return strategies, infrastructure, and macro/trading strategies.

Beta

Correlation, however, does not capture relative risk – beta does. Beta measures risk relative to the equity market and can be used as a way of managing the market-sensitivity of a portfolio. Furthermore, beta takes into account both relative volatility and correlation. Unlike volatility, the beta of a portfolio is the weighted sum of the betas of the individual assets. Knowing this can help investors to control the risk of their equity allocation.

Introducing alpha

Alpha is, ultimately, what investment managers have to generate to justify their fees. Essentially, it is the “X-factor” of a portfolio’s return and cannot be explained by general market movements (beta). A portfolio’s return is equal to the alpha plus beta, and is generated from active stock selection and tactical asset allocation. Although it is not risk per se, it can help us to assess how far a manager has deviated from his or her objectives.

Drawdown potential

Drawdown measures a loss from peak to trough and is useful in ascertaining an investor’s appetite for risk. It may sound obvious, but investors have a better chance of generating a higher return if they do not lose money in the first place. This is even more crucial now that capacity for loss is a key regulatory definition of risk. As mentioned earlier, low volatility does not mean low risk and it can still disguise the threat of substantial drawdown.

For example, an investor holding commercial property in 2007/2008 would not have found much solace in knowing that the 35 per cent drawdown (loss) was incurred with low volatility. Worse, the greater the drawdown, the more risk is needed to recover that loss – some of the figures are astounding, and much greater than one may expect. In order to retrieve a 20 per cent loss, a 25 per cent gain is needed in order to break even; for a 50 per cent loss, this figure jumps to 100 per cent. By the time we reach a 90 per cent loss, a 900 per cent gain is needed just to break even.

Sharpe ratio

The Sharpe ratio is a risk-adjusted measure of return. It measures the excess return above cash per unit of risk (volatility), although it does not differentiate between good and bad volatility. To put it simply, it measures the efficiency of the risk in a portfolio and not just the return. For example, a Sharpe above one is generally accepted to illustrate a good return; a negative Sharpe would mean that investors would have been better off in cash. The aim for investors, therefore, is to maximise their Sharpe, and one way to improve the ratio is to invest in uncorrelated assets.

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