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Rethinking risk

Risk assumptions affect how we view opportunity too.
Image: Shutterstock

Market participants all want the same thing: the best possible return at the lowest level of risk. How you go about securing that, however, is often a source of disagreement. While you might think investment is a black-and-white affair, the assumptions that you use to underpin your calculations can have a decided influence on your decision to invest – or not.

Of course, future returns are never certain (and even in fixed income markets, bond holders could default). But add changing macroeconomic variables, irrational markets, unrealistic expectations and investor emotions into the mix, and getting to certainty becomes even more difficult. No wonder many investors settle for the ‘obvious answer’ – whether this is picking last year’s winner or simply following the crowd, which has invested in a combination of popular offshore stocks and cash of late. Using such decision-making shortcuts can often lead investors astray, and while there are always risks to doing so, we believe the current market environment has elevated the risks of taking such shortcuts even more.

Markets have become bifurcated, with investors clamouring to invest in the strategies that have proved successful in the past, and so it becomes a self-reinforcing cycle, with popular winners continuing to win.

What is risk

Risk is often defined as the potential to lose money, though it should also be viewed as the possibility that your return expectations won’t be met. In a world of deeply divergent markets, the definition of risk for many seems to have shifted to the ‘risk of missing out’.

Exuberant and irrational markets create opportunities for patient investors who are prepared to look for the opportunities others are missing out on. These are typically found in the uncrowded sectors of the market. Currently, markets are defining risk very narrowly as the ‘risk of missing out’ and more specifically, the ‘risk of missing out on a repeat of the returns from a narrow subset of assets’.

Risk assumptions affect how we view opportunity too

Being careless about the assumptions that underpin your estimations of fair value and future returns will sway your investment choices. Therefore, we believe that investors should be very clear about what their assumptions of the future imply, to minimise the risk of being disappointed later.

Perceived ‘low risk’ assets like US government bonds are offering very little yield, while the S&P 500 is at generational extreme ratings. Previously when the S&P ratings were in similar territory between 1998 and 2000, investors had to wait 13 years before seeing a capital gain (and weather two corrections of more than 45%). With ratings already at such extremes, investors should question how much longer such conditions can persist – and what it could mean for portfolios if their underlying assumptions were proven wrong.

More worrying, however, is that current risk perceptions are blinding investors to the areas of the markets that do offer the potential for exceptional future returns, even when we apply currently very negative assumptions that underpin popular narratives. Thus investors are not only investing into a very narrow subset of assets driven by a fear of ‘missing out’, but they are also avoiding investment into broad range of assets based on prevailing narratives that these assets are ‘too risky’.

As we methodically unpack the narratives around what is ‘too risky’, however, we often find they stubbornly overlook any mitigating factors, and are based on deeply held narratives of fear. The risks of investing in SA Government Bonds are widely discussed (and potentially overstated) while the appeal of high yields and steep yield curves are overlooked. SA Inc shares are all assumed to be write-offs based on poor economic prospects, when these companies have proven they can fare well despite the local economy and even when these companies do not depend only on the South African consumer and economy.

Yes, investors want “the best possible return at the lowest level of risk” but this is dependent on your ability to correctly assess what risk is. If you get that fundamental insight wrong, your ability to invest successfully in the long term, will be severely compromised.

Anet Ahern, CEO at PSG Asset Management

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I am passionate about this topic of investment risk. The investor displays the level of sophistication of his thought processes in the way he perceives risk. Whether he realises it or not, when he puts the money on the table, to make an investment, he has made a bet that reflects his perceptions about risk.

This process is so daunting to many novice investors that they simply abandon it altogether, to abdicate their responsibility to the operator of a Ponzi-scheme! They avoid the potential corrections and slower gains on the regulated market, to embrace the far bigger risk of the loss of capital in a Ponzi-scheme. They exchanged one relatively harmless type of risk for another, far more damaging risk.

So, there are stupid risks and clever risks. The clever investor does not take the risk in unregulated entities and accepts the market risk. The stupid investor fears the market risk and joyfully accepts the risk of the loss of capital in unregulated schemes. The relative growth of the investment is simply the result of the perceptions about risk.

It is always the ignored and unanticipated risks that hurt you. The idea is to identify the various risks, to quantify the seriousness of that risk, and to manage that risk. Success follows risk management and not risk-avoidance. Risk avoidance leads to a guaranteed loss of capital. The return on a low-risk bank deposit is negative, after inflation and taxes. The investor in an interest-bearing instrument exchanges the market risk for a guaranteed loss of purchasing power.

What sets investors apart is their risk-management strategies, not how lucky they are. The sophisticated investor will ask his fund manager about his strategies to identify and manage risks, and not how he performed over the past 3 months.

We all pay for how we perceive risk. Life itself is a risky endeavour. Good luck!

Problem is there is this 18 month period (talking US equities) that you feel like a real Dick holding 3% yield investments while all around you others are doing 13%

Please roll on the slap around the head with a vrot snoek that the US is way overdue.

End of comments.

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