When it comes to investments, there is a plethora of terms relating to risk - from tracking error, standard deviation and volatility to drawdown risk.
A good way to look at investment risk is to view it as the probability of incurring a permanent capital loss over a particular period. Using this framework, you would put risk at the forefront of investment decisions.
There are a number of good reasons for putting risk first in an investment process. These include:
1. Protecting the base. This is the simple reality of needing to make up more than you lost to get back to where you were. For example, if you lost 20%, 35% or 50%, you need to return 25%, 50% and 100%, respectively on the money you have left in order to be in the same position before the loss. Preventing losses is important. It’s not a symmetrical picture. You need to invest with a margin of safety, which means making sure the investment and associated risks are understood, well researched and that the price is cheap enough, given the potential upside and downside.
2. Carefully consider non-ideal outcomes. If you put risk first in your investment process, you are forced to consider more scenarios when it comes to investment outcomes. In that way, you are prepared to make changes as a non-ideal scenario unfolds and rectify the situation. Your manager is also more likely to plan for protection of value than one who is primarily focused on the upsides.
3. Diversification reduces risk. Putting risk first means portfolio construction involves true diversification, across asset classes (where appropriate), industries, regions and individual shares. This is essential to decrease the concentration of risk associated with having too many eggs in one basket.
4. Be fearful when others are greedy. Putting risk at the forefront of your investment process puts you in a better position to buy when others are fearful and sell when they are greedy. It is only when you have spent a lot of time considering all the risks that you can have the conviction to be contrarian when you need to. After the long period of poor market returns we have seen, it is conceivable that the largest risk facing the individual investor is to capitulate and abandon a solid long-term strategy that will keep them invested in growth assets in a responsible way. Allied to this, the toughest task for advisers at present is to help clients not to make across-the-board or emotional decisions in the face of uncertainty and in the wake of poor historic returns.
5. Choose a custodian. Putting risk first means that a manager should be a custodian of the investor’s investments and preferably manage their funds as if they were managing their own money. If they are co-investors in the funds they manage, they are much more likely to make the correct long-term decisions needed to generate safe returns. They are also likely to invest in companies that are managed by teams that generate good returns, as they are themselves significant shareholders in their businesses. It becomes a partnership, as opposed to an exercise in finding something you hope someone else will buy from you at a higher price.
Putting risk at the forefront of investment decisions enables a manager to make the correct long-term decisions in the best interests of their investors, and ultimately will provide both the peace of mind and the returns investors need.
Anet Ahern is the chief executive officer of PSG Asset Management.