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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.

 

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