Risk aversion is a complex issue which I have previously discussed (see ‘There’s more to risk aversion than most planners realise’). Across the super fund industry, I see many intriguing case studies, and managing for these challenges is important for both large funds and SMSFs. As superannuation assets under management continue to grow, more people will need to decide how they think about risk aversion.
A quick refresher on risk aversion
Financial risk aversion defines our attitudes to taking financial risk. In academic literature risk preferences can take many forms, including absolute risk aversion and relative risk aversion – it is these two on which I focus in this article. Absolute risk aversion means that our risk aversion relates to a dollar amount. Relative risk aversion means that our risk aversion relates to a percentage of our portfolio. So as a portfolio grows in size, all else equal, an individual whose risk preferences take the form of absolute risk aversion would prefer to shift into a less aggressive portfolio while an individual whose risk preferences take the form of relative risk aversion would not change their investment strategy. It’s an important distinction.
A 1% loss is easier to take than $1 billion
Mark Delaney is the highly regarded CIO of Australian Super, the largest super fund in Australia with in excess of $90 billion in assets. But Mark will likely have an undesired record: the first Australian super fund CIO to lose $1 billion in a day. Of course this should not reflect poorly on Mark as it is largely a function of the large assets under his management.
How do super fund CIO’s, and indeed managers of any large asset pools, deal with numbers of this size? In my case I have many days where the funds I manage make or lose $50 million. Clearly the mindset needs to be one of relative performance. A 1% loss sounds more digestible than $1 billion! Relative risk aversion is probably the preferred lens through which risk is interpreted in this instance. If CIO’s were focused on the absolute numbers then we are talking big numbers which will only become larger.
Let’s consider the case of someone with an absolute risk aversion mindset. I once worked with a proprietary trader who consistently returned an excellent profit on a small capital base. The bank noted his good return on capital and doubled his capital. The trader’s percentage risk levels halved and he made the exact same dollar profit as before! This is a case of very strong absolute risk aversion in practice.
What if a super fund CIO had absolute risk aversion tendencies? As their fund grows they would be inclined to take the same amount of dollar risk and thus the percentage risk would drop. This could well be to the detriment of the fund’s members who require growth to achieve their retirement outcomes. Is there a place for an absolute risk aversion mindset amongst super fund CIO’s? I would argue not: after all super funds are managing pooled funds on behalf of many members. The risk taken on their behalf should not be influenced by the overall size of the fund. Though I do not love the fact that the industry remains so peer group focused, this represents one positive aspect. Peer grouping ensures that super funds consistently take the amount of risk that the industry deems necessary to take the lead to achieve retirement outcome goals (whether this is the right amount of risk is the big issue for another day!). Effectively peer grouping forces a relative risk aversion mindset.
So are super funds consistent in their application of a relative risk aversion mindset across all of their business? I believe there are inconsistencies. For example I met a director of a super fund recently who was talking about delegation of decision-making. The director found it hard to delegate any decisions, even on a small proportion of the overall portfolio, to the investment team because the dollar size was very large. Clearly this suggests absolute risk aversion characteristics. A mismatch of the form of risk aversion preferences across super fund executives and directors could lead to less effective decision-making and unnecessary tensions.
It is important to note the role of media, too. The media like to attract attention. If we return to our Mark Delaney example, which is more likely to attract readers: “Australian Super loses 1% in a day!” or “Australian Super loses $1 billion in a day!”? Clearly the latter – which suggests that media by necessity has an absolute mindset. As super funds grow in size the risk of adverse media increases, which in itself risks a bad reaction by super funds.
Risk in SMSFs
The issue of appropriate risk preferences is not as clear cut for SMSF trustees. The key difference is that an SMSF is most commonly established for a single or a couple. In this sense the account could be viewed as a personal or joint savings account and so elements of relative risk aversion and absolute risk aversion could both be relevant.
It could be important to maintain a percentage level of portfolio risk as the fund grows in size because this is necessary to grow the asset pool to support the desired retirement outcome. However an absolute mindset may come to the fore as the absolute size of gains or losses could be felt quite tangibly by the SMSF trustee in terms of the impact on their retirement outcome.
What if an SMSF has strong absolute risk aversion tendencies? They might reduce risk as their fund grows in size. This risks the fund not growing as much as is necessary to achieve targeted retirement outcomes. An SMSF trustee could also consider some risk scenarios. For example “I stand to lose $50,000 if CBA shares drop to $60. Perhaps I should diversify into other Australian stocks.” An absolute risk aversion mindset potentially leads to more technical risk management mistakes of diversifying the portfolio into areas where the trustee may have less conviction while also not realising that the SMSF would remain heavily exposed to a drop in Australian shares.
Conclusion
Risk aversion is a complex but fascinating area where there is still much to learn. The examples highlighted demonstrate that both relative and absolute risk aversion preferences exist in industry and among SMSFs. There are risks to the effective operation of both large funds and SMSFs in not understanding their own biases. For large super funds the main risk could be inefficiency and tensions due to a mismatch of risk preferences amongst key staff. For SMSFs a strong absolute risk aversion could stop retirement goals being reached and be a catalyst for other risk management mistakes.
David Bell is Chief Investment Officer at AUSCOAL Super. He is working towards a PhD at University of New South Wales.