All investments come with risk

Short term government bonds are considered to represent the risk-free rate of return, although history shows the world is littered with defaulted government bonds, so all investments involve some element of risk.

At the lower end of the risk spectrum are cash investments, although if we want to play the devil’s advocate, even these carry risk. For example, if you only earn 3% interest, pay tax of 37% on the interest – and inflation comes in at over 1.89%, you are losing money – in real terms. So, the very real risk in cash investments, is the risk that you won’t achieve your investment objectives, as your nest egg will not even keep up with inflation.

How to better manage risk

When investing, the following risks are possible:

  1. Capital loss: We may lose some or all of our invested capital, or, in some cases, even more than our invested capital, in the case of leveraged investments; or
  2. Disappointing returns: We may not get the returns we expected.

None of us like risk, however, we know that all investments come with varying degrees of risk, and if we want to earn better than the risk-free rate, which most of us do, we understand that risk is a necessary evil. Therefore, the question is not how can we avoid risk altogether, but how can we best manage risk?

Firstly, we should look at history, as we can’t see the future. Whilst history is not a perfect guide, it’s all we have, and as they say, “History doesn’t repeat itself, but it often rhymes.”

A few key considerations in managing risk:

  • Avoid unnecessarily high risk. Some risks are too high, and may result in a large or total loss – so avoid these altogether;
  • Diversify risk. Avoid overexposure to any one particular risk, such as share market risk;
  • Minimise risk. Don’t take any more risk than you need to in order to achieve your return objectives;
  • Make sure risk pays off. You should be well compensated for the risks you choose to accept;
  • Look at your whole portfolio. Risks should be considered in the   context of an overall portfolio, rather than only in isolation; and
  • Spread risk across time. Ensure that risks in your portfolio are unlikely to all eventuate at the same time, such as during a severe equity market decline.

Some investments are too risky

For example, imagine you were considering investing in a small business. According to the Australian Bureau of Statistics, more than 60% of small businesses cease operating within the first three years of starting.  And research by Shikhar Ghosh, a senior lecturer at Harvard Business School, states that about three-quarters of venture-backed firms in the U.S. fail. So if you invest in just one small business, there’s more than a 60% risk of failure. That’s a big risk, so you would need to think this through very carefully, particularly if it requires a large capital investment, or you’re nearing retirement, because should you lose the capital, you will have less time to replace it.

What about a share investment? Whilst shares have increased in value over the long term, history shows that shares suffer a fall, on average, of around 35% every 3.4 years. Warren Buffet says, “We shouldn’t own common stocks if a 50% decline in their value in a short period of time would cause acute distress.” Again, how old are you, how much of your net worth are you investing in shares, and how would you feel if you lost half of your capital?

Property can also suffer considerable falls, and long periods of 15-20 years with no real growth in value.

The key before investing, is to go in with your eyes wide open, and make sure you’re comfortable with the risk, as well as the return, of any investment you’re considering, as there’s no point in getting all excited about the return, and then pulling out when the inevitable risk eventuates. Growth assets, such as shares and property, do produce better long-term returns than cash, but they are obviously considerably more volatile, and to ultimately receive the higher long-term returns offered by growth assets, you need to be able to stay in your investor seat for the long term, especially when the ride gets bumpy. The inability to do this, typically turns expectations of long-term returns into the reality of short-term losses.

Can risk be measured?

Sure, it can, just not by any single measure – risk needs to be considered from many perspectives. Investment professionals define risk as the level of uncertainty of achieving the returns expected. The key word here is “uncertainty”, as there are no guarantees regarding future returns, and should we seek any form of guarantee when investing, it comes at a price, as does any form of insurance – and it will of course therefore reduce the overall return.

This uncertainty can be measured, although a full understanding of risk always requires more than just a few simple statistics. The most common way of measuring this uncertainty of returns is by the variation from the average annual return, known as the standard deviation. Let’s look at an example:

Standard deviation – what it means

Assume the average annual return of an investment for the last ten years has been 10%, and the standard deviation is 10% – what does this mean?

Naturally, the ideal investment is one that has a good average annual return with a low standard deviation.

It means that about 68% of the time, you could expect your annual return to be somewhere between +20% and 0% (i.e. one standard deviation from the average annual return), and about 95% of the time, the returns should be between +30% and -10% (i.e. two standard deviations from the average annual return), and about 99% of the time the returns should be between +40% and -20% (i.e. three standard deviations from the average annual return). Of course, the above statistics are based on what is referred to as a “normal distribution”, however, according to Professors Fama and French, “Distributions of daily and monthly stock returns are rather symmetric about their means, but the tails are fatter (i.e. there are more outliers) than would be expected with normal distributions. The message for investors is: expect extreme returns – negative, as well as positive.”

What this means, is that we can expect more returns in the three standard deviations or more range than in a normal distribution. This is backed up by the data. For the S&P 500, there have been 25 bear markets (a fall of 20% or more) since 1929, which is an average of one about every 3.5 years – and the average fall has been 35.43%.

The standard deviation is still very useful as an indicator of the riskiness of an investment, as, armed with the average annual return and the standard deviation of each investment, we can start to assess our likely range of returns. It is obvious that the lower the standard deviation the better. For example, compare these two investments: both Investment A and Investment B have an average annual return of 10% per annum over the long term. However, Investment A has a standard deviation of 5%, whilst Investment B has a standard deviation of 20%.

The problem is that we never know what order the returns will come in, so it makes sense to seek out investments with a low standard deviation, as it gives investors much more certainty of achieving a range of returns they are comfortable with. Naturally, the ideal investment is one that has a good average annual return with a low standard deviation.

What is the Maximum Drawdown?

There is a second measure of risk that investors need to also be aware of – the Maximum Drawdown. The Maximum Drawdown is the biggest fall that has been experienced by an investment. Of course, this doesn’t necessarily mean that the investment may not experience a larger drawdown in the future, and it also doesn’t mean that each investor has lost this much of their capital, unless of course they bought in at the very peak. The Maximum Drawdown of any investment is based on past results, which will obviously not be exactly repeated in the future, but it shows the extent of losses which have occurred in the past. The longer the historical period under examination, and the greater the range of market conditions covered by this period, the more relevance may be placed on the Maximum Drawdown statistic. For example, if you bought shares in an Index Fund tracking the Australian All Ordinaries Index at the end of October 2007 (just before the GFC), you would have suffered a drawdown of over 54% in 16 months.

The importance of the Maximum Drawdown, is that it can highlight what we refer to as “tail risks”. We call these tail risks, as in statistical terms, they occur more than 3 standard deviations from the average, i.e. at the outer edges of a distribution – in the tails (see example below of what is known as a normal distribution), meaning they don’t happen very often, but when they do, the results can be devastating. Of course, of great concern to investors is the left tail, which is where extreme losses are shown in a return distribution histogram (as below), so when we speak of “tail risks”, we are referencing the possibility of an investment, or a portfolio, suffering an extreme loss, which is expected to be an infrequent occurrence – but one we must still consider.

Distribution of returns of an investment over a long period of time

Tail risks become even more important as investors age, as there is little time to recover from a wipe-out. Some examples of extreme events are the US share market in the Great Depression, which fell approximately 86%, and as mentioned above, the 54% fall in the Australian share market in 2007-2008. It makes sense to reduce your exposure to highly volatile investments if you’re over the age of 50, and ensure that your portfolio is able to safely navigate a wide range of economic conditions, and doesn’t suffer dramatically in one particular scenario. It is also useful to look at the 5 worst drawdowns of any investment, as it provides a deeper understanding of what is possible.

Further, although we have shown a diagram above of a “normal distribution”, investment returns are not normally distributed. Most investments have what is called a leptokurtic distribution. This is not just some irrelevant statistical distinction that you can impress people with at cocktail parties – it has real world relevance for your financial future, as it effectively means that extreme losses occur with a much higher frequency than would be predicted by standard statistical measures. Looking back over a long history of US financial market data, we see that corrections (i.e. a loss greater than 10%) occur on average approximately once per year, and bear markets (i.e. losses greater than 20%) occur approximately every 3.5 years.

As an illustration, in the table below, we show the 10 largest drawdowns in the S&P 500, in the almost 90 years since January 1928. The average of these drawdowns is 40%, and it took, on average, over four years to recover these losses.

The 10 Largest Drawdowns in the S&P 500

We show the history of the S&P 500 Index below. Clearly, the market has always recovered and made new highs, but the ride has been anything but smooth. It is worth considering the table above, and asking yourself how you would have felt in each of these drawdowns – would you have held on with nerves of steel – or sold out amidst the panic?

Beware the Black Swan Event

We know what you’re probably thinking. What do big black birds have to do with financial risks? The term was made famous by Nassim Nicolas Taleb, a finance professor, writer and former Wall Street trader, and the history of the term derives from the 16th century, at a point in history when all swans were believed to be white (the black swan was therefore a mythical creature). A Black Swan event is a significant deviation from expectations, typically characterised by events of economic/financial significance, that result in large losses. What makes a Black Swan event special, is that it is both extreme, and practically impossible to predict. We know that such events WILL happen – we simply don’t know when, or in what circumstances. The Global Financial Crisis and sub-prime meltdown is typically considered a good example of such an event.

During the GFC, AAA-rated securities plummeted in value dramatically (theoretically, they should not have, as AAA-rated securities are the safest).

In the realm of investing, it is usually safe to assume that when there is a disparity between theories and actual events, it is the theories that are wrong (i.e. the events are not as supposedly unlikely as we are led to believe). The key to effectively dealing with Black Swan events is not to try to predict them – that is a fool’s errand. Dealing with Black Swan events effectively, means constructing an investment portfolio that is capable of coping well with a wide range of occurrences, dramatic changes in expectations, and rapidly shifting circumstances.

Contingent risks: Thinking through the “what-ifs”

Some investments have quite a low standard deviation, and a low Maximum Drawdown, and yet they may sustain significant losses under certain circumstances. These investments appear to be low risk, and they may even work very well for many years, but they are vulnerable to massive losses. We call these risks contingent risks – they are not visible all the time, but we know they are there, even if they are not obvious from looking at typical risk statistics. The key to understanding contingent risks, is to think in terms of “what-if” scenarios, and think about how the investment would perform in these scenarios. This is a thought experiment, not an exercise in mathematical precision. In the case of contingent risks, mathematical precision is typically less relevant, as if the “what-if” scenarios occur, losses are typically massive. To properly understand contingent risks, we must dig beyond data, and understand the economic characteristics of the investment.

Subprime mortgages

A typical example of an investment that can appear to carry much less risk than it really does, is a mortgage fund. When a rate of return is offered by a mortgage fund that is significantly higher than normal mortgage rates, it is because the borrowers are not first class.

The sub-prime mortgage crisis

A recent example of the damage that can be done by accepting lower credit quality, was the sub-prime mortgage crisis in the US that triggered the GFC. Where a “prime” loan is a loan that typically meets the lender’s standard criteria, a sub-prime loan, by definition, does not meet the lender’s standard criteria. These sub-prime loans were packaged into mortgage-backed securities and collateralised debt obligations, and many of the funds who invested in these suffered a total loss of capital in the US sub-prime crisis.

Mortgage Funds

These investments can appear to be low risk, as whilst the financially unsound borrowers pay the mortgage, the annual returns come in like clockwork, with very low volatility, i.e. they just pay the interest on the loan, however, the borrowers themselves are questionable, which is why they couldn’t meet the standard lending criteria in the first place. The problem is, that the circumstances that cause one unsound borrower to default, may very well trigger an avalanche of defaults.

In Australia, these mortgage funds (that often appear safe, due to the consistency of their returns) lend money to property developers, and the question investors should ask is – why are the returns on these investments much higher than the mortgage rates charged by banks? The answer is both simple, and logical. It is because the loans are considerably riskier, and the banks won’t therefore lend to these borrowers, who may have a poor credit history, lack experience in property development, or take on high risk developments in oversupplied markets with little or no pre-sales – so they seek out mortgage funds who will lend to them, albeit at much higher rates, which puts even more strain on the success of these projects, as the holding costs can quickly absorb all the profit when the sales dry up.

Ask yourself, if the banks won’t lend to these borrowers, why should you? After all, you are probably in a worse position than a bank to absorb the loss. Remember, banks are experts at lending money – it’s their core business. In a credit squeeze, these loans are often the first to default. Many elderly investors are enticed into these investments, which appear like a money machine, and can even work like one for years, until they don’t. Many of these funds disappeared during the GFC, but they re-emerged in 2009, and are once again gaining in popularity. Of course, Australia didn’t suffer the property market fallout that many other countries did during the GFC, however, this has only created false confidence in the robustness of a market that is leveraged more than ever before.

Several organisations issuing warnings about mortgage debt

There have been a number of warnings by credible organisations regarding the high level of mortgage debt in Australia, and the concerns over the property market.

Warning from APRA

According to an article in The New Daily on 31 May 2017, the boss of Australia’s financial regulator joined the list of commentators worried about Australia’s high level of mortgage debt. Wayne Byers, chairman of the Australian Prudential Regulation Authority, told a Senate Estimates committee that it represents “one of our higher risk factors at present”.

“We have never hidden behind the fact that we are in an environment of heightened risk. Prices are high, household debt is high, interest rates are at historical lows, income growth is low, competitive pressure is strong in the housing market,” he warned, the Australian Financial Review has reported.

“So, everyone has to be fairly careful about how they operate.”

Mr Byers commented on the move by high-profile fund manager Altair Asset Management to liquidate its Australian share funds on concerns of an impending property market “calamity”, saying it was an “extreme response to the circumstances”.

Warning from ASIC

Australian Securities & Investments Commission chairman Greg Medcraft labelled the market a “bubble” while Deloitte Access Economic has estimated prices are about 30 per cent overvalued compared to incomes.

Warning from the RBA

A third of homeowners have accumulated no mortgage repayment “buffer”, exposing them to income shocks and rising interest rates in the increasingly fragile housing market, according to the Reserve Bank of Australia.

When assessing risk, use your common sense

To summarise our discussion regarding risk, seek out investments that exhibit a low standard deviation and low maximum drawdown – the lower the better. Also, carefully consider the presence, and possible impact, of contingent risks, and how your portfolio will perform in a range of economic scenarios. As a guide, a standard deviation under 5% is exceptional (this level of volatility is typical of conservative assets), and under 10% is reasonable, and look for investments that have not suffered historical drawdowns of more than 20%. For example, if you lose 10% of your capital, it only requires a very achievable 11% on the remaining capital to recover, however, if you suffer a drawdown of 50%, it requires a return of 100% on the remaining capital to recover, which is extremely difficult. The following table shows what return is required on the remaining capital to recover the loss, after suffering different sizes of drawdowns/losses. This table clearly shows that, whilst small losses are quite easy to recover, large losses are extremely difficult to recover, and should therefore be avoided.

Setting risk objectives

There is nothing wrong with taking appropriate, and well considered, risks. After all, that is the entire point of portfolio management, as not taking appropriate risks effectively guarantees failure. However, we recommend investors carefully consider the following key points when setting risk objectives for their investment portfolio, including their self-managed super fund:

  • Minimise risk where possible: don’t take on any more risk than you need to in order to achieve your investment objectives (i.e. ensuring that you hold an efficient portfolio);
  • Learn how to calculate risk: there are many ways to measure risk, however, the most common measures are standard deviation and maximum drawdown. You need to understand what these are, why they are both very important, and what their limitations are;
  • Beware of tail risks: tail risks are risks that only happen rarely, or based upon certain scenarios (i.e. contingent risks), but the consequences can be devastating, and can result in substantial, or total loss of your capital. These risks need to be carefully assessed, as some seemingly safe investments are more prone to these risks than others. For example, lending against first mortgages appears safe, as the returns come in very consistently – until they don’t. When there’s a credit squeeze, or property market oversupply, and property values fall, these investments can suffer catastrophic losses, as happened in the GFC, when many property owners faced a situation where their mortgage ended up exceeding the value of their property;
  • Risk diversification: it is critical that not all your investments are exposed to the same risks – for example, share market risk. In a share market correction, you can be diversified across hundreds of shares, but if the whole share market collapses, it won’t help you. And when the share market collapses, property prices often eventually suffer from the fallout, so investors need to include investments that have the ability to perform well in a rapidly falling share market. Regrettably, most investors have portfolios that are dominated by share market risk, as even a 50-60% allocation to shares can lead to 90-95% of portfolio risk being related to the share market;
  • Seek out investments that display lower volatility, i.e. a low standard deviation: most investors don’t pay enough attention to volatility, with the key aspect being the standard deviation, which is arguably, the most important determinant of risk. One thing about volatility that is certain – the more volatile the investment, the higher chance there is of losing some, or all, of your capital, and the higher the chance you will exit the investment at an inopportune time. In fact, before they invest, most investors focus primarily on the historical return of an investment, and only after they have invested do they become aware of the psychological strain caused by volatility;
  • Risk-adjusted return: ensure you are being well compensated for the risks you choose to accept. The object is to achieve the best possible return for the risk taken;
  • Don’t underestimate risk: a common mistake made by investors, is to assume they are taking less risk than they really are, especially where they are invested in assets that are very familiar to them. Whilst familiarity with a particular investment certainly might make you feel better about it, it doesn’t really decrease its risk, and this is especially problematic where familiarity/comfort with a particular asset class leads to a concentrated (undiversified) portfolio. When analysing investment portfolios of self-proclaimed “conservative” investors, we often find they are taking huge amounts of risk – and they’re not even aware of it. Don’t find out the hard way; and
  • Consider the timing of risks: under what conditions will each investment in your portfolio be likely to sustain a loss. If everything that you own is likely to perform badly at the same time, you are carrying a lot more risk than someone with a portfolio that will experience smaller losses at varying times. This is a critical, and often overlooked, point. What effects the long-term viability of your portfolio, is not so much the total overall quantity of losses, but how these losses might cluster together. As an analogy, if you pepper somebody with 10,000 one-gram pebbles, you are likely to annoy them, however, if you hurl a 10-kilogram stone at their head, they are unlikely to fare all that well. Losses are the same in the context of a portfolio – you want to keep losses small, and spread out through time, rather than large and clustered.

Setting return objectives

  1. Firstly, let’s go back a step: is the risk of the investment acceptable? If not, don’t even worry about the return, as if you lose all your capital, or sustain losses from which you can’t recover, there won’t be any need to consider further returns (we highly recommend reading our article on sequencing risk);
  2. Focus on the likely long-term returns of an investment: most investors look at how an investment has performed in the last year, which is a proven mistake, as last year’s best performer is rarely the best performer the following year. A much better indication of the long-term performance of the strategy is to look at the return since inception (as long as there is ten years or more of data), or if the investment manager uses a mathematically defined (quantitative) strategy, ask if you can view the back-tested data of the investment strategy for at least the last ten years. These returns will not have been generated with “real money”, but they will allow you to understand how the strategy being implemented today has performed historically. This longer-term focus is what is important, as last year is gone, and you need to make a decision based on what returns may be achievable over the longer term;
  3. When considering asset class returns, use history as your guide: for most asset classes, data is available for over a century. When considering an absolute return investment, or active investment, look deeply at the strategy behind the performance – ask yourself, does it make sense, is it grounded in sound theory, has it been thoroughly tested, how diversified is it, how well is the risk managed (look at the historical standard deviation and maximum drawdown, plus consider any contingent risks);
  4. Determine how correlated are each of your investments are to the others: ideally, you will combine various investments that can perform well under different economic conditions, as the ideal portfolio should combine investments that all perform well (good return, conservative to moderate risk) over the long term, but at different stages of the economic cycle. A common mistake made by investors, is to hold most of their wealth in bonds, shares, and property. Rising interest rates cause bond values to fall, and property affordability to drop, resulting in falling bond and property prices. Increased borrowing costs (i.e. rising interest rates) also reduce corporate earnings, and result in falling share prices. Some investments sit on top of cash, and are not adversely affected by rising interest rates, but can actually benefit from them;
  5. Prepare yourself for the long haul: good investments work most of the time, but no investment works all the time, so be prepared for the odd poor period of performance from time to time. Provided the investment is sound, it should recover, and go on to achieve its long-term returns. Most investors jump ship at the first sign of bad performance. Usually they leap into an investment that has had a good recent run, only to find it then experiences a lean period, and the investment they left then has a very good year. Rather than chop and change, investors should change their investments less frequently, and only after careful consideration of the long-term benefits. Remember, a long-term portfolio will need to survive periods of high/low inflation, and high/low economic growth and assets and investment strategies will perform differently in different economic environments. The key is not in trying to time markets, but in building a portfolio that will provide an acceptable return at a reasonable (and comfortable) level of risk, irrespective of the economic environment; and
  6. Income is the key: ultimately, your investment portfolio will need to produce a sufficient income for you to live off, and fund your retirement goals, which means that liquidity is important, at least for part of your portfolio, as is keeping pace with inflation.