Understanding risk in an investment context
As we approach the festive season and look forward to spending time in the company of family and friends, the events caused by the eruption of Whakaari (White Island) seem all the more tragic. For those people caught up in this event, what should have been an interesting and exciting end to 2019 has ended in suffering and grief.
To me it is a salient reminder that in life we run risks all the time. Sometimes we take these risks knowingly and at other times we do this through ignorance. The reality is that when we don’t experience a negative consequence personally we can easily become complacent; we end up discounting the true risk that we are taking.
I was recently talking with a client who works as a chemical engineer in petroleum exploration. He was explaining that in their industry there are some potential outcomes that are so horrendous, that merely reducing their probability is not enough. The goal has to be the practical elimination of those risks.
As an adviser, I encourage my clients to think about the risks they face when investing under three headings: volatility risk, liquidity risk and the risk of permanent capital loss.
Volatility risk relates to the variability of returns. This risk is the one that most clients intuitively understand; you can accept a low return with low volatility, or you can seek a higher but more variable return. Your ability to profit from this risk is generally governed by your investment timeframe (i.e. how long you can wait to achieve the desired return) and your investment temperament (i.e. are you emotionally capable of continuing to hold an investment during a negative period).
The risk questionnaires advisers often have their clients complete before making investment recommendations seek to understand the client’s response to volatility. Once this parameter is understood an adviser can create a portfolio blended from cash, fixed interest, property and share investments. There are good statistics to help guide both the client and the adviser in the discussion about the trade-off between the average rate of return they may receive and the risk they are taking. However, it is important to understand that investors can transform volatility risk into permanent capital loss if they lose their nerve and exit at the bottom of a market cycle.
The second risk is liquidity risk. This is the risk that you might not be able to access your investment when you need to, or you may need to sell at a discount to access it. Direct property investment is an example where liquidity risk can exist. The difficulty is that quantifying this risk in advance is problematic. Whether you can find a buyer at the price you want at some future point in time is generally unknown. If you are going to accept liquidity risk, then what additional return should you be paid as compensation? In my view, many investors tend to discount this risk.
The third risk relates to the possibility of permanent capital loss. For most clients this risk is not too dissimilar to the extreme risk described by my chemical engineer. The impact of permanent capital loss can be catastrophic. Holding a number of separate investments can help manage this risk. However, the experience of investors in finance companies during the global financial crisis showed that it is possible for an entire sector to come under pressure and experience permanent capital loss. Fraud is another potential source of this risk.
The reality is that we humans have short memories. When investment markets have performed well for an extended period (as has generally been the case of late) we often underestimate the risk that we are taking.
Investment risk can never be completely eliminated and in fact it is the acceptance of risk that helps drive return. However, as mentioned in introduction, it is the risks that we are taking through ignorance that tend to blindside us. The role of an experienced adviser can help you identify and manage the range of investment risks that you face.
Wishing you and your family a risk-reduced festive season.
To me it is a salient reminder that in life we run risks all the time. Sometimes we take these risks knowingly and at other times we do this through ignorance. The reality is that when we don’t experience a negative consequence personally we can easily become complacent; we end up discounting the true risk that we are taking.
I was recently talking with a client who works as a chemical engineer in petroleum exploration. He was explaining that in their industry there are some potential outcomes that are so horrendous, that merely reducing their probability is not enough. The goal has to be the practical elimination of those risks.
As an adviser, I encourage my clients to think about the risks they face when investing under three headings: volatility risk, liquidity risk and the risk of permanent capital loss.
Volatility risk relates to the variability of returns. This risk is the one that most clients intuitively understand; you can accept a low return with low volatility, or you can seek a higher but more variable return. Your ability to profit from this risk is generally governed by your investment timeframe (i.e. how long you can wait to achieve the desired return) and your investment temperament (i.e. are you emotionally capable of continuing to hold an investment during a negative period).
The risk questionnaires advisers often have their clients complete before making investment recommendations seek to understand the client’s response to volatility. Once this parameter is understood an adviser can create a portfolio blended from cash, fixed interest, property and share investments. There are good statistics to help guide both the client and the adviser in the discussion about the trade-off between the average rate of return they may receive and the risk they are taking. However, it is important to understand that investors can transform volatility risk into permanent capital loss if they lose their nerve and exit at the bottom of a market cycle.
The second risk is liquidity risk. This is the risk that you might not be able to access your investment when you need to, or you may need to sell at a discount to access it. Direct property investment is an example where liquidity risk can exist. The difficulty is that quantifying this risk in advance is problematic. Whether you can find a buyer at the price you want at some future point in time is generally unknown. If you are going to accept liquidity risk, then what additional return should you be paid as compensation? In my view, many investors tend to discount this risk.
The third risk relates to the possibility of permanent capital loss. For most clients this risk is not too dissimilar to the extreme risk described by my chemical engineer. The impact of permanent capital loss can be catastrophic. Holding a number of separate investments can help manage this risk. However, the experience of investors in finance companies during the global financial crisis showed that it is possible for an entire sector to come under pressure and experience permanent capital loss. Fraud is another potential source of this risk.
The reality is that we humans have short memories. When investment markets have performed well for an extended period (as has generally been the case of late) we often underestimate the risk that we are taking.
Investment risk can never be completely eliminated and in fact it is the acceptance of risk that helps drive return. However, as mentioned in introduction, it is the risks that we are taking through ignorance that tend to blindside us. The role of an experienced adviser can help you identify and manage the range of investment risks that you face.
Wishing you and your family a risk-reduced festive season.
***
Peter Ashworth is a Principal of New Zealand Funds Management Limited, and is an Authorised Financial Adviser based in Dunedin. The opinions expressed in this column are his own and not necessarily those of NZ Funds. His disclosure statements are available on request and free of charge.
***
First published in the Otago Daily Times on 12 December 2019, as ‘Investors should be conscious of three types of risk.’
