Regardless of your chosen route to investing, understanding and taking into account the risk of your chosen assets is essential.
Systematic and Non-systematic risk
Unsystematic risk can be thought of as the risk generated by factors specific to the stock or share, such as a poor management team, changes to regulation or other event driven risks. By investing in a number of different companies, this ‘specific risk’ can be significantly diversified away. Increasing the number of holdings reduces risk only so far, studies have shown that there is little to no additional benefit in holding more than 35 companies in different sectors.
Systematic risk, often called ‘market risk’ is deemed undiversifiable as it pertains to the financial system as a whole. Sentiment will drive markets up or down as measured by changes to an index. The change in price to an individual equity on any given day will in part be a reflection of these market fluctuations. Professional investors measure market risk by beta (β) – a share with a beta of 1.0 is expected to move exactly in line with the market.
Risk Adjusted Performance Measures
Looking at outright performance in isolation is a common but dangerous business. Provide most novice investors with a list of investments attaching the performance figures for each, and ask them to select their top 10 picks. Most would select the investments that have performed the best over the previous 1, 3 or 5 years without taking care to analyse and assess the risk taken to achieve those returns.
Risk adjusted measures factor in both the performance and the relative risk of an investment to give a more useful value with which to make buying decisions. The share that marginally outperformed over the past 3 years but whose management team took huge gambles to deliver the profits is unlikely to be able to repeat their success. Conversely, an investment that has marginally lower risk characteristics than its sector average but delivers consistently high returns indicates a sustainable process and is perhaps a safer bet.
For example, the ‘Sharpe Ratio’ shows the excess return per unit of risk associated with the excess return. The benchmark used is the ‘risk free’ rate of return. The higher the ratio, the better the risk adjusted performance – a useful ratio for investors comparing the relative returns of an asset over cash.
Another useful ratio when looking at investment funds is the ‘Information Ratio’ (IR) which factors in the outperformance of a portfolio and the tracking error (how ‘off-piste’ the manager skied from the benchmark). A high IR indicates the manager used the information about markets to identify price anomalies better than his peers.
Quantifying and understanding ‘total risk’
A measure commonly used to quantify the volatility of returns an investment is the standard deviation (SD) of its returns around its ‘mean’ or expected return. SD gives us a feel for the total risk of an investment (systematic risk plus non-systematic risk = total risk).
If an investment behaves ‘as expected’ producing returns, year on year, close to the average return of the investment, then we consider this ‘low risk’. Conversely, if the returns fluctuate widely around the average return the investment can be considered as ‘higher risk’.
If a given investment has a high expected return, then it usually carries a higher than average degree of risk rendering it inappropriate for people wanting to take a cautious stance. By the same token, if two potential investments have the same expected return, but one is half as volatile, then this ‘lower risk’ investment is perhaps more attractive.
If your time horizon is short for a given investment and the standard deviation value is high, then the risk of having to crystallise a loss at the point of encashment is elevated.
Advice on Risk & Risk Assessment
Calculating and understanding the downside potential of the investment an individual holds is a key responsibility of the financial adviser.
The volatility of a ‘balanced’ (a common label used in retail fund investing) fund a few years ago may well look completely different today, effectively leaving an investor with a different portfolio to the one originally selected. A possible solution here is to use a mix of asset specific funds that are regularly reviewed and rebalanced allows tighter controls of ongoing risk.
We offer a comprehensive analysis and assessment service of existing portfolios, reporting on the historic, current, and prospective risk associated with the assets /funds held within it. We can advise and recommend if any changes are required to create outcomes that are in line with expectations and objectives.