Evaluating risk and its potential effect on future gains is an essential part of any investment strategy, write Eugene Kiernan and John Flavin.
Too many investors pay mere lip service to the concepts of risk and return. They focus too much on the returns they want and not enough on the risks they are taking. Investment managers who achieve the highest returns routinely win awards but there are no glitzy ceremonies to recognise excellence by investment professionals – be they accountants, fund managers or advisors – in managing risks.
That may well be down to human nature as when markets are rising, investors tend to think positive. They want their fund manager to achieve higher returns than anyone else. Those who deliver the highest returns are often viewed as the best in the business. Only the best-informed investors tend to quantify the risks being taken to get these returns, however.
It is typically only when markets fall that investors’ focus shifts to risk. It is only then that they worry less about gains and more about minimising their losses. Unfortunately, many investors realise the importance of risk when it is too late and markets have already moved against them, eroding or even destroying the gains achieved when markets were rising.
That is why, when it comes to deciding on how to invest, quantifying risk is every bit as important as quantifying return.
The risk/return relationship
Every investment professional is familiar with the mantra that they must take on higher risks to achieve higher returns. This is a theory that deserves closer scrutiny. It is true that investors who take higher risks should demand higher returns, but it is equally true that higher risks do not necessarily result in higher returns. Rather than focusing solely on returns, investors and their advisors would benefit from a greater focus on risk-adjusted returns – that is, the extent to which their gains are dependent on higher-risk investments.
Measuring return alone does not paint the full picture. For example, if an investor is deciding between Fund A and Fund B, she or he may see little difference between them if Fund A has delivered 11 per cent over the past three years while Fund B has delivered 10 per cent. The picture changes dramatically, however, if the investor is then told that Fund A (perhaps containing a high proportion of tech start-ups, exploration stocks and investments in emerging markets) is a lot riskier than Fund B (containing a highly-diversified portfolio with investments across asset classes and geographies).
In this example, an investor in Fund A is taking significantly more risk than an investor in Fund B, and is much more vulnerable to a downturn in a particular sector or in emerging markets. While the return is higher, is the difference big enough to justify the additional risk? An informed decision can only be made if the risk is quantified and the expected return adjusted accordingly.
Measuring volatility
Volatility is a key feature of risk-adjusted return analysis. In essence, volatility measures the likelihood that the return generated by an investment will fall outside a limited range. Lower volatility suggests that the return generated will be steadier and more predictable, allowing investors to meet their goals over the long-term without being hit by significant and often inevitable market downturns along the way. It was Warren Buffett who once said that the first rule in making money is making sure not to lose it. In other words, the key to long-term success is protecting against downside risk and avoiding the big drops. Irish investors, more than most, learned the lesson during the financial crash that years of gains can be wiped out in a very short time. On the flip side, it can take a very long time to repair the damage a significant downturn can do to a portfolio with significant risk exposure.
There is strong evidence that riskier portfolios underperform compared to portfolios that take steps to mitigate risk. In other words, the gains riskier portfolios make in good times are outweighed by the losses suffered when markets fall. For example, a study of global equity funds by global asset management firm Blackrock that covered the performance of mutual funds between 1986 and 2014 showed that the “safest” 20 per cent of portfolios achieved significantly higher annualised returns than the “riskiest” 20 per cent. The study also showed that, when it came to comparing the risk-adjusted performance of portfolios, annualised returns actually decreased as volatility increased).
The superior performance of low-volatility equities stems from their ability to protect in times of market stress. For instance, low volatility stocks performed significantly better than broad market indices in the market meltdown of 2008. They had less ground to make up than those that had fallen further, which meant that holders of riskier stocks suffered more and suffered for longer.
While there is a wide array of risk measures available, most investors will focus on volatility of returns as a shorthand tool to assess risk. Indeed, most fund providers highlight this measure in their literature, as do many performance league tables. The Sharpe ratio, which looks at returns delivered, adjusted for the degree of risk being taken, is a useful way of establishing the relative efficiency of an investment strategy or fund. A high Sharpe ratio means the risk-adjusted returns are higher.
Conclusion
Riskier stocks do not necessarily mean better long-term returns. In fact, the opposite is true. More volatile portfolios tend to get hit excessively on the downside and fail to match gains made by less volatile portfolios on the upside. Some riskier stocks have risen in value as the market is basing a significant part of its valuation on future performance and expectations are high. When these high expectations aren’t met, the fall from grace can be severe. That is not to say that investors should shy away from riskier stocks and riskier portfolios – far from it. They are perfectly legitimate investments, but it is crucial that the level of exposure taken by an individual investor fits with her or his requirements and risk appetite.
The bottom line is that serial compounding over a number of years is the basis for sustainable returns. Evaluating risk and the effect this risk may have on future gains is an essential part of any investment strategy. Ultimately, risk is not to be avoided but it must be managed well.
Eugene Kiernan is Head of Investment Strategy at Appian Asset Management. John Flavin FCA is Senior Relationship Manager at Appian Asset Management.