Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 22

Simple investment risk management – this is the risk issue we need to talk about

I feel Chris Cuffe’s article ‘We need to talk about risk’ (Cuffelinks 21, 27 June 2013) may understate the benefits of aspiring to best practices in investment risk management. While it is hard to quantify the benefits of risk management (a claim also easily made of other important areas such as governance) this does not mean it should be discounted. Chris laments the use of volatility as a measure of risk, and I agree on this. But risk management is far more than the calculation of volatility; it is an unfair perception of risk management professionals to think they only calculate volatility. Those associated with the retirement savings of Australians need to strive for best practices in risk management. Many super funds already do much more than just calculate volatility. Perhaps it is the difficulty in communicating risk to non-financially literate people which is the issue – and it is this which has led to the use, and subsequent criticism, of the relatively simple measure of volatility.

Explaining complex topics to non-experts is a difficult challenge. Many industries face these communication challenges. How do you communicate the complexity in products such as cars, or medical procedures such as heart surgery? I’m sure we don’t want to see advancements in these areas slow down so that the communication process is easier, and I feel likewise about risk management. There are two issues at play here. One is the need to constantly improve risk management practices. And the other is the communication challenge of explaining to people that their risk is well managed.

It is unfortunate that there is no single measure of risk – life would be so much easier. Alas, risk is a complex beast and there are many different sources of risk, some of which we may not even have considered. The industry often paints risk managers as ‘quants’ or ‘pointy heads’ but the best risk management teams I have seen have been able to marry the science and the art of risk management. The best examples generally combine a mix of quantitative techniques (and continual development in this area) with the qualitative overlay of experienced people. The discretionary piece cannot be understated. Understanding the environment where models or inputs are unlikely to be reliable is crucially important. Unfortunately good risk management does not guarantee the avoidance of bad outcomes – but we still have to do our best.

If all risk represents is the calculation of volatility and this was the only risk management tool we had, then we would have even more bank failures, insurance company bankruptcies and super funds delivering disastrous results. In fact we wouldn’t need risk management teams – a simple model could do this job. Risk management would be nothing more than risk reporting. There is much more to managing risk and there are some great examples across the industry. If you ever have the privilege to meet firms with top risk management, the confidence it gives you that they understand the risks that may adversely affect their performance is very comforting. While nothing is guaranteed they are doing their best to manage the risks in their portfolios. Surely everyone deserves this, whether it is well-communicated or not.

The concept ‘best practice risk management’ cannot be defined. We do not know every possible source of risk that may affect portfolio outcomes. And models are only tools which attempt to estimate the possible outcomes. The inputs used in these models are simply estimates, hence the importance of qualitative judgement and experience. Indeed some of the best case studies in risk management have involved the judgement of an individual person.

When I am asked to analyse the risk management practices of a fund and its managers, I look for:

  • how they define risk
  • risk awareness and their understanding of possible sources of risk that may affect them so that their portfolio represents risks they appreciate and are prepared to take on
  • active risk management and not just risk reporters
  • the systems (and the quality of those systems) they use to estimate risk along with their understanding of the limitations of those systems
  • the resourcing of the risk management team
  • the experience of the risk management team and their preparedness (and authority) to overwrite what their models are saying.

I do agree with Chris that volatility is a simple risk management tool with many flaws (an article for another day). Simple volatility calculations are frustrating for all involved - frustrating for those communicating with investors because of its flaws in explaining risk and frustrating for risk managers as well because there is so much more to good risk management than simply calculating volatility.

We shouldn’t hold back the aspiration of best practices in risk management by tainting it with the perception that risk management is simply calculating volatility. Risk management is not risk reporting. It is much more and good risk management is critical to protecting financial outcomes. How to communicate risk and how risk is managed are different issues.

 

2 Comments
Paul Meleng
July 04, 2013

Fund managers should employ on the team a scarred old fart like me. Someone who has actually worked in the field for years as a surveyor for land development, mineral exploration, construction and utilities and then in real estate sales and then insurance and finally financial planning and who has a huge network of "real" people to check with. And someone who has actually seen plenty of things go wrong and been "conned" a few times too many. A classic from 1990 was Estate Mortgage where it turned out that the properties securing loans were construction holes in the ground when the lending was supposed to be limited to 65% of value of fully completed and tenanted buildings. Did anyone go and look for all the buildings and maybe get a lift maintenance certificate on any of them before giving the investment the tick ? Or consider, during the 70's nickel boom my mates and I used to get paid to go bush and see if the exploration tenements being traded had actually been pegged in the field. My dad ran hotels. He said "count the kegs". If all one knows is what one has read on paper or seen on a powerpoint presentation what does one believe? And yet you need both quants and people who walk around looking and asking awkward questions. The more variety in experience and ways of looking at things the better. Apart from analysing the risk characteristics of the type of investment (which is of course a first point for helping naive investors as clients) the risk of buying the actual investment at the current price has to be the first test. Thanks for the intelligent writing and discussion.

Steve Romic
July 04, 2013

Nicely put … a considered and balanced response to Chris’ earlier article.

The aversion doesn’t stop at standard deviation … to many, statistical approaches to risk management have been relegated to the rubbish bin – perhaps because it’s challenging to build and implement a framework that is both robust and rigorous...?

It shouldn’t come down to a “for” or “against” argument … best practice, as you put it applies both qualitative and quantitative processes to better measure, monitor and manage risk.

 

Leave a Comment:

banner

Most viewed in recent weeks

Which generation had it toughest?

Each generation believes its economic challenges were uniquely tough - but what does the data say? A closer look reveals a more nuanced, complex story behind the generational hardship debate. 

100 Aussies: seven charts on who earns, pays, and owns

The Labor government is talking up tax reform to lift Australia’s ailing economic growth. Before any changes are made, it’s important to know who pays tax, who owns assets, and how much people have in their super for retirement.

The best way to get rich and retire early

This goes through the different options including shares, property and business ownership and declares a winner, as well as outlining the mindset needed to earn enough to never have to work again.

A perfect storm for housing affordability in Australia

Everyone has a theory as to why housing in Australia is so expensive. There are a lot of different factors at play, from skewed migration patterns to banking trends and housing's status as a national obsession.

Chinese steel - building a Sydney Harbour Bridge every 10 minutes

China's steel production, equivalent to building one Sydney Harbour Bridge every 10 minutes, has driven Australia's economic growth. With China's slowdown, what does this mean for Australia's economy and investments?

Supercharging the ‘4% rule’ to ensure a richer retirement

The creator of the 4% rule for retirement withdrawals, Bill Bengen, has written a new book outlining fresh strategies to outlive your money, including holding fewer stocks in early retirement before increasing allocations.

Latest Updates

Economy

The ‘priced out generation’ and what they should do about it

A fiery interview on housing exposed deep generational divides, sparking youth outrage and political backlash. As homeownership drifts out of reach, young Australians face a choice: fight the system - or redefine success.

Taxation

Maybe it’s time to consider taxing the family home

Australia could unlock smarter investment and greater equity by reforming housing tax concessions. Rethinking exemptions on the family home could benefit most Australians, especially renters and owners of modest homes.

Superannuation

Meg on SMSFs: Ageing and its financial challenges

Ageing SMSF members can face issues funding their pension income as cash reserves dwindle. Potential solutions include involving adult children in contributions to secure future financial stability.

Economy

US earnings season was almost too good to be true

The second quarter US earnings season has wrapped up, with a record 82% of S&P 500 firms beating earnings estimates. As tailwinds fade, Q3 may reveal whether AI momentum can offset rising economic headwinds. 

Gold

Does gold still deserve a place in a diversified portfolio?

9,000 years and no devaluations later, gold is the world’s most enduring store of value. It remains attractive as the value of several paper currencies, including the US dollar, are threatened by deficits and rising debt.

Shares

Checking in on the equity market's silent engine

Consumer spending directly impacts corporate earnings, sector performance and market sentiment. The latest data from different economies uncover risks and pockets of opportunity for investors.

Fixed interest

6 key themes driving bond markets

The Fed could soon be prompted to join other central banks in cutting interest rates. This would have ripple effects across global fixed income markets and provide an especially attractive backdrop for emerging market bonds.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.