The meaning of risk

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By Grant Alexander, Director of Private Client Holdings

grantThe meaning of risk is not quite as profound a question as the meaning of life, but is as perplexing.

Asset managers understand it perfectly – risk is simply the volatility of your returns. The less that the returns fluctuate, the less risk there is in the portfolio. Thus, if a fund manager’s portfolio offers a smoother ride over time then there is more certainty and it is regarded as less risky than the fund manager that produces a lumpier return profile with bigger ups and downs. Makes sense? Well, sort of….

Individuals typically regard risk in behavioural terms i.e. “I prefer stable returns”, “I am adventurous”, etc. and after the completion of a questionnaire, are placed in boxes such as conservative or aggressive. This could be framed as an attitude to risk and is linked to volatility which implies the choice of a smoother or bumpier ride.

Individuals are also motivated by the need for risk which emanates from their goals (to maintain a standard of living during retirement, to educate children, etc.).  Thus, if their goals are modest they would not need huge returns and could therefore invest in a portfolio of low risk assets delivering pedestrian returns but without much downside. If they choose goals which are possibly beyond their means, they will require higher returns with the commensurate increase in risk. So from the individual’s perspective it’s all about the need. No need to look further then? Absolutely not.

The third and most important component of risk is the capacity for loss. This is the amount of loss that an individual can absorb before suffering irrevocable financial harm. Beyond this point, it would be impossible for individuals to realise their goals. This is measured as the maximum drawdown of a portfolio. It is important that a detailed analysis is conducted to assess your capital adequacy.

The table illustrates the link of the portfolio quants to the three areas of risk:

Portfolios Return Volatility Max Drawdown
Conservative 2% 6% -10%
Moderate 4% 9% -20%
Aggressive 6% 15% -40%
NEED ATTITUDE CAPACITY

*Table taken from a presentation by Chris Gilchrist of Fiveways

It is important that wealth managers ensure that all three aspects of risk – attitude, need and capacity – are taken into account when tailoring appropriate portfolios. Each individual has a different combination of these risks which will change over time and underscores the importance of partnering with a wealth manager attuned to these nuances.

What is clear is that the preoccupation of asset managers with volatility is not useful as a proxy for risk for individuals.  Volatility does not guarantee immunity from a black swan event such as the global financial crisis. From the individuals’ perspective what is paramount is the capacity for loss.

For more information contact Grant Alexander at Private Client Holdings on (021) 671 1220 or visit www.privateclient.co.za.