Due diligence on the risk of investment is fundamental to investors, advisers and fund managers. No one wants to lose money, whilst the holy grail is to obtain strong investment returns with minimal risk. The problem is defining what risk is, especially as the term is variously understood by different commentators. The key message in this blog is that volatility and risk are not the same. It is my contention that risk is more complex and nuanced than volatility, whilst the latter can be used as a beneficial investment strategy or even as an asset class in its own right.
I define risk as the potential of losing some or all of your original investment. For single stocks, especially smaller companies there is a risk of complete loss whilst for pooled investments or funds the chances of complete loss are extremely low. We’ll look at volatility before explaining why I consider it does not necessarily equate to loss.
Volatility & Loss
Volatility measures the up and downs of stockmarket returns, the sizes of the peaks and troughs. For the technicians amongst you volatility is the standard deviation around a mean. Naturally you would expect commodity stocks to be more volatile than utility companies or pharmaceuticals. The former invest in the highly cyclical and economically sensitive resources sector whilst the latter are defensive companies with stable cash flows. However if we define risk as the chances of losing all your money, a commodity company investing in a highly volatile sector is not inherently more at risk of becoming insolvent. It may have a very strong balance sheet and other strong fundamentals.
Similarly gilts backed by the UK Treasury are less volatile than high yield corporate bonds because UK PLC has a higher creditworthiness than corporate issuers of low grade debt. However here volatility is a good measure of the risk of loss. This is because a company issuing high yield debt is more likely to default with investors losing money compared to holding UK government debt or a company bond with a higher credit rating.
Volatility & SRRI Ratings
The most common measure of risk in respect of collective investments such as unit trusts is volatility and this appears in the Synthetic Risk & Reward Indicator (SRRI) in Key Investor Information Documents (KIIDs). As you may be aware these are statutory fund disclosure documents that must be issued to clients prior to investment under EU regulations. Each fund is risk rated on a scale of one to seven based on volatility of returns over the previous five years. I have several issues with SRRIs. Firstly the ratings are based on historic volatility; they do not take into account current market conditions nor are they forward looking. As such using the well-worn adage, they are not necessarily a guide to future returns. A fund with high volatility in the last five years may not be so volatile in future if market conditions or the management style of the fund changes.
Secondly in my experience SRRI ratings of most equity funds almost always a six and this includes UK equity income funds as well as global emerging markets funds. Whilst there are complexities of comparing the risks of these two sectors, for example UK companies have considerable overseas earnings including from emerging markets, it cannot be right in my view to conclude the risks are identical. For example global emerging equities tend fall sharply with “risk-off” sentiment, with a flight to quality and there is typically greater currency risk, political and corporate governance risk. In conclusion SRRI ratings do not distinguish the true risks of investment in different equity markets and if used in isolation they provide an incomplete assessment of the potential for volatility or loss.
Fixed interest, including government and corporate bond funds have lower risk ratings on the SRRI scale than equity funds and are typically rated a four. So does the lower historic volatility mean fixed interest is lower risk than equities? Not necessarily. Government bonds are subject to interest rate risk, also referred to as duration risk, whilst corporate bonds are subject to interest rate risk, credit or default risk and liquidity risk. The latter has been a problem in recent years and will be covered in a future blog. The risks with bond investment are clear. If there is an unexpected spike in inflation or interest rates rise there could be a sharp sell-off in government bonds as in 1994 whilst the corporate bond market could seize up. Volatility would spike.
In summary an SRRI rating can be a poor measure of the potential for loss as it does not account for current systemic risk issues. A bond fund may have demonstrated lower volatility than an equity fund in the past but this does not necessarily make it a less risky investment given that interest rate risk, credit risk or default risk are not features of equity investment.
Finally an SRRI rating discounts current risk mitigation measures by fund managers who naturally take a forward view. Options to reduce interest rate risk include investing in short dated or high yield bonds, which are less interest rate sensitive or by shorting the market.
Risk & Loss
Many investors define risk quite simply, succinctly and correctly, “What are the chances of me losing money?” This accords with my definition of risk above.
However consider the following scenario. You invest £50,000 and six months later you receive a valuation statement showing the portfolio is worth £45,000. You are advised that stockmarket returns have been poor due to a global sell-off of equities. The question here is, “Have you actually lost money?” The answer is no unless you cash out and thereby crystallise the loss. If you continue to hold the investments your loss is a technical or paper loss based on a valuation snapshot at a specific point in time. The following week, month or six months the position will be different. A year later the portfolio may be valued at £55,000. Now I don’t want to trivialise this downside scenario; no-one likes to see a paper loss but fortunately most of my clients have a long term investment timescale and understand that volatility does not mean a real loss unless it is crystallised.
In some cases it is prudent to sell a loss making investment to re-invest elsewhere because the sector, asset class or current fund management has poor prospects for recovery. In many cases however a long term buy and hold strategy is required. That said to avoid being a forced seller at low valuations because money is needed urgently it is advisable to hold sufficient emergency cash savings. This acts as a portfolio protector permitting flexibility to delay encashment until values recover.
Despite these comments some investors are so cautious that they cannot accept a valuation lower than the amount that has been invested and hence equities may be unsuitable investments for them.
Volatility should not always be seen as an enemy as it provides potential for greater investment returns. It is used by traders and fund managers alike. Frequently the latter say they have added to their best stock ideas on the dips and troughs. Volatility can also create valuation anomalies if the market over reacts on the sell side whilst volatility is the friend of the regular monthly investor who acquires more units in a fund when buying on the dips.
This blog is intended as a general investment commentary. You should seek individual advice before making investment decisions.