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We need to talk about risk

After nearly 30 years in the investment management industry I can say without hesitation that the thing that irks me most is the use of the word ‘risk’ and what it actually is. In my view it is the most misused and ‘glossed over’ of all the plethora of investment jargon that exists.

The word ‘risk’ is a bit like the word ‘love’. It has multiple meanings depending on who is using the word and in what context. You can love your dog; you can love your sister; you can love your child; you can love football; you can love your wife or husband. These uses of the word love all evoke different feelings and they each have a completely different connotation and context. And so it is with the word ‘risk’.

One of the better definitions of risk I have seen comes from Elroy Dimson, Emeritus Professor of Finance at the London Business School:

“Risk means more things can happen than will happen.”

In the superannuation investment industry people seem to talk about risk as though it means the same thing to all people. But it clearly does not. Risk is very different in the eyes of the client (the person with the superannuation account) versus the investment manager versus the regulator.

Let’s look at each.

The person with the superannuation account

My 24-year-old son has a superannuation account with a major industry fund. When I talk to him about risk and what matters concerning his account his answer is straight forward:

  • when he contributed to the fund he wanted to know the money arrived safely (aka no one ran off with it)
  • whenever he receives a statement he wants to be confident the information shown is correct (aka there is integrity in the underlying data systems)
  • when he wants to access his money in future years he knows it will be there (aka the institution is credible and reliable and not a ‘fly by night’)
  • the money is being competently invested
  • the fees are fair (aka he is not being ripped off)
  • if provided, the insurance will kick in if a relevant event occurs to him.

I’d also add on his behalf, since he’s unlikely to be focussing on this yet, will he have accumulated enough money at the end of his working life to live on?

In any case, there’s not much here on the standard industry definition of risk, the volatility of returns.

The investment manager

When managing a fund that many others are invested in (that is, a managed investments scheme) the investment manager is trying to invest in one way to suit the needs of many. However, he or she does not know the attributes, attitudes, timeframes and needs of the ‘many’ and so by necessity must manage the investments with one eye shut.

The investment manager thinks of risk in terms of the following:

  • volatility of the value of an individual asset
  • volatility of the valuation of an asset sector (usually based on history)
  • concentration risk (having too few securities in a portfolio)
  • differentiation from competitors
  • differentiation from the benchmark being used to measure the performance of the fund.

And most investment managers measure the above things over quite short time periods, often less than a year, and indeed are usually remunerated based on ‘success’ over one year periods.

The regulator

And then of course we have the regulator. Whilst I am sure the regulator thinks of risk very widely, it seems to me they want trustees to adhere to some of life’s basic rules:

  • be honest and fair
  • take your role seriously, both in the way you act and your knowledge and skill
  • try your hardest
  • if you make a mistake say sorry and rectify it
  • don’t receive a personal benefit at the expense of your clients.

I have a short and simple book called Life’s Little Instruction Book, by H. Jackson Brown, which records personal observations from a father to his son to help him in his life. I sometimes wish our law-makers would use it and save paper!

So where are we going wrong on risk?

With these multiple facets to the word ‘risk’, where does this leave us?

I believe there is a high misallocation of resources, energy and intellect across the superannuation industry (and investment industry more broadly) to address risk. The media use the word risk in quite a sensationalist manner, often without proper definition and logical timeframe for measurement. And I believe regulators have a thirst to micro manage risk and even attempt to eliminate risk, as though this unquestionably gives a better outcome, and without proper regard to the cost and benefit of what they are seeking to achieve.

And most talk about risk in investment circles in a one dimensional manner, being the volatility of the value of an asset, when this is often meaningless without appropriate context.

Analysts report as though risk can be measured or adjusted with pin point accuracy, using phrases such as ‘too much risk’ and ‘risk-on, risk-off plays’, when this is simply not the case.

The wisdom of Howard Marks on risk

The best overall summary I have read on risk is contained in Chapter 5 of Howard Marks’ The Most Important Thing, Uncommon Sense for the Thoughtful Investor. Although many investors in Australia may not know of Marks, he is well known in the US investment industry and in my opinion he is up there in wisdom with Warren Buffet. Buffet himself said of this book, “This is that rarity, a useful book.”

Marks makes the point that according to the academicians (his word, not mine!) who developed capital markets theory, risk equals volatility, because volatility indicates the unreliability of an investment. Marks takes great issue with this definition of risk, as he doesn’t think volatility is the risk most investors care about. I agree. Like Marks, I think the possibility of permanent capital loss from owning an asset is at the heart of what investment risk is truly about, followed by the possibility of an unacceptably low return from holding a particular asset.

Marks believes much of risk is subjective, hidden and unquantifiable and is largely a matter of opinion. He makes the point that investment risk is largely invisible before the fact – except perhaps to people with unusual insight – and even after an investment has been exited. And in the following words he points out a profound paradox:

“Return alone – and especially return over short periods of time – says very little about the quality of investment decisions. Return has to be evaluated relative to the amount of risk taken to achieve it. And yet, risk cannot be measured. Certainly it cannot be gauged on the basis of what ‘everybody’ says at a moment in time. Risk can be judged only by sophisticated, experienced, second-level thinkers.”

Marks makes the obvious observation that in dealing with risk there are three steps: understanding it, recognising when it is high, and controlling it. I believe we have a long way to go in understanding risk, particularly which risks matter the most, which surely must be those that impact the end investor the most (like my 24-year-old son). And I believe we must all have a far better framework of thinking to decide which risks we should allocate time, cost and resources to minimise or eliminate, versus those risks we should simply accept.

What does a better risk framework need?

What do we need in this risk framework? Risk is primarily about losing money and not meeting a realistic financial goal that you set out to achieve. Volatility or standard deviation of returns is at best a side issue. It’s convenient because statistical calculations allow a number to be put on risk, but it’s not really what matters.

Short termism has created an obsession with volatility. It would be preferable to prohibit the publication on performance numbers with less than 12 months of data.

I believe the really important things for investors are as follows, and if these matter for the clients, then they should also be the focus for trustees and regulators:

  • prevention of fraud, such as the use of an independent custodian
  • credibility and reliability of the institution investing the money
  • experience, competence and integrity of the people doing the investing
  • understanding by clients of investment markets and alternative choices (ie education)
  • diversification of investments and avoidance of asset concentration

The regulator should focus on making the system honest and fair, and ensure both its own staff and those in the industry have appropriate skills to meet their obligations.

We can employ the best market experts, compliance officers by the dozen, regulators from every government department imaginable, and have committee signoffs, board approvals and obey every regulation in the land. And then something like the GFC can hit a portfolio, or there can be an environmental disaster, or an act of terrorism, and the best risk management in the world will not prevent a loss of capital. Spread sheets and management reports create an over confidence that we can recognise and understand risks in advance.

As Howard Marks says, and I wholeheartedly agree, the possibility of a permanent capital loss from owning an asset is at the heart of what investment risk is truly about. And ultimately, there’s not much that can be done to wholly prevent these risks.



Behavioural reasons why we ignore life annuities

Getting the most from your age pension

Expect disappointment as values become stretched

October 10, 2019

My risk definition: 'Of all the things that can go wrong, which are most likely.'

Ramani Venkatramani
August 19, 2013

Mea culpa.

In my enthusiasm to plead for better risk management, I wrote in my comment "The rule of law morphs here as a malapropism into the lure of lawyers."

Apologies to the cognescenti. I should have, instead, said: "The rule of law spooneristically spawns the lure of lawyers".

This shows that actuaries with literary pretensions (who would have imagined?) are a danger to civilised discourse, well within a whisker of identity theft!

Duly chastened....

Ramani Venkatramani
August 18, 2013

Graham's alert is timely. It especially applies to SMSFs, the forgotten sector in regard to any substantive regulation (compliance checking not enough).

To enhance our response, I believe we should frame the issues from a behavioural perspective. Such adaptation is to finance what modern physics is to Galileo, Newton and Einstein. Ignoring it serves us short.

Looked at this way, for each of Graham's segments
1) risk is assessed subjectively, as in what will harm me? The member looks at losing the nest egg; the manager the annuity stream and market share; the regulator (its credibility and perhaps funding); advisers their fees (potential black-listing); Government over or under legislation and destruction of market confidence.
2) for given risk (however defined) identical amounts of losses matter more than profits. Even institutions are so affected as they comprise humans after all
3) When things go wrong, legislative enforcement (especially in common law adversarial as distinct from civil law truth-seeking regimes) could shift the burden to victims rather than perpetrators. In super for example, the emphasis is often on intermediary trustee and adviser / auditor rights to earn their living, to the cost of affected investors. The rule of law morphs here as a malapropism into the lure of lawyers.
4) Especially in our super dominated by defined contribution, where all risks rest ultimately with members in this ill-capitalised industry incapable of cushioning the risks as in banking and insurance, member disengagement exacerbates the impact. The traditional response that in a loss, member balances are written down ignores the societal consequences of a melt-down.
5) Electoral cycles and the resulting political myopia hamper visionary leadership.
6) While securing citizens' retirement is the right public policy, our regime also facilitates a tax-concessional way of providing inheritance for kids and grand-kids. This is unsustainable: if we consider the family home exemption for Centrelink & CGT, absence of gift & inheritance taxes, post-60 tax-free super benefits and the worsening dependency ratio against the poor economic outlook, the inference is dire, calling for vision that transcends three year horizons.

As Paul Keating, who was endowed with the rare vision of compulsion in super, once said (words to the effect): 'In any race, bet on a horse called 'self-interest', it will always come first'!

Wolf Schumacher
July 29, 2013

Thanks for this great article and comments.

Bill Keenan
July 19, 2013

I agree that standard deviation or volatility are inadequate measures of risk as volatility is usually very low at a market high, and high at the market low. So an investor is actually exposed to major risk when the sd or vol are very low and giving you a green light. And the best time to invest is usually when the vol has been elevated for some time and everyone is bearish. Nassim Taleb’s “Black Swan” book covers this well.

Scott Barlow
July 05, 2013

Most ordinary retirement savers have zero opportunity to manage risk at the product or portfolio level. This job is left to the product or portfolio manager (as it should be).

And yet, many financial planners would have their clients believe that portfolio/product/asset class risk management is a big part of the planning process. In practice, this is simply not true. It doesn't happen.

Planners - often assisted by asset consultants - make assumptions about the stability of risks (and returns) at the product or individual asset class level, they combine a number of products/asset classes into portfolios and they then communicate the total risk to their investor clients through labels such as 'Conservative' or 'Balanced' or 'Growth' etc. The truth is, the assumptions are usually wildly unfounded (risks and returns are inherently and notoriously unstable) and once the product or asset class risk finds itself in the client's portfolio, i.e. at the total portfolio level...very, very little is done to actively manage the risk so that it remains "true to label". Investors ultimately get whatever risk the market dishes up.

Ordinary superannuation savers would be much better served by the investment industry if funds (and perhaps entire client portfolios) were managed to a pre-nominated risk target than the current focus of managing to asset allocation benchmarks. This was a recommendation of the Cooper Review. Aside from the adviser gaining much needed confidence that the risk that they represented was the risk the client actually the fact that it would avoid anchoring clients (with limited time to work, save and invest) to portfolios of asset classes that are ocasionally overtaken by market circumstances.

Standard deviation (when explained as volatility) is a term broadly understood by the majority of investors. A portfolio with a standard deviation of 14% is twice as "risky" as a portfolio with a std dev of 7%.

Industry bodies (e.g. ASFA, APRA) have called for our industry to take a quantifiable approach to the expression of portfolio risk but shamefully not much has happened. It would be a positive step forward for the financial planning industry because investment managers would be unable to hide behind wishy-washy labels and comparing portfolios (and thus investment options) would become much more straightforward because investment returns would be judged by the risk taken to achieve the return, which is the great leveller for all Funds and all Fund Managers.

The vast majority – if not all - ordinary superannuation funds in Australia are constructed as strategic asset allocations where there is little or no active management of total risk in the portfolio. As such, volatility (risk) outcomes in these portfolios can vary considerably over time, which leads to unwanted surprises, which in turns leads to disappointment and disillusion amongst unsophisticated investors. If, as the Cooper Review recommended, investment options were labelled by the level of total risk in the portfolio rather than by asset class (with highly variable and unmanaged ‘risk’), investors would be better placed to understand the amount of risk they are actually exposed to leading to better informed investment decisions much more aligned with investor goals and objectives.

David Bell
July 03, 2013

My concern with Chris's view and some of the comments is that the aspiration to have the best risk management practices possible will drop away because people cannot see the tangible benefits of risk management or that it is too hard to communicate what risk is and how it is managed. Every ardent risk manager should likewise be beating their chest!

While some of the comments above take the interesting perspective that risk differs by personal circumstance (and I agree on this), this shouldn't restrict people from striving to manage the risks in products and portfolios where personal characteristics are not known.

I think we need to more clearly separate the challenge of communicating risk and how it is managed from the ongoing challenges of understanding and managing risk. Indeed finance is not the only industry facing these challenges - how do cars communicate their technology, how are complex medical procedures explained and so on?

Anyway I take my points further in this week's edition of Cuffelinks!



Peter Vann
July 01, 2013

Good to see an excellent article putting risk in context. I would like to dig a bit deeper in superannuation land.

The OED description of risk is “the possibility of loss, injury, or other adverse or unwelcome circumstance”; this puts some context on risk if one understands the problem at hand. In the case of investments, they usually fund a liability, implicitly or explicitly, so risk relates to not reaching the goal.

Given that a super fund’s primary purpose is to provide retirement income, it seems sensible that risk relates to outcomes adversely affecting a member’s retirement income. Taking this view cash can be riskier than equities for most workers, and even for many retirees.

Provided equities are not overly expensive, a young person investing in cash up to retirement usually has a higher likelihood of providing a lower retirement income compared to investing in equities when account is taken of investment volatility. Thus for this situation, cash is quite a risky investment with respect to funding the liabilities. Why is it so? Over time the higher expected return of equities increasingly offsets their higher volatility since volatility over an increasing number of years increases slower than returns.

Even for many retirees, analysis of the impact of investment volatility on the risk of funding a retirement income will generally show that cash still has higher risk. But now the risk from investing in equities will have increased somewhat as there is less time for the higher volatility of equities to be offset by the higher returns. The retiree may find that some middle ground strategy delivers a retirement income with less risk (of not funding the income).

In a recent paper we have looked at the impact of investment volatility on the risk of funding retirement income for a range of members with different ages and levels of fundedness. Our main conclusion is obvious: the nature of this risk is highly dependent on individual circumstances and the nature of your retirement goals. One-size-fits-all products and dogmas are bogus, and can increase a member’s retirement funding risk. Wouldn’t it be nice if every super fund member had access to tools that illustrated in a simple way their individual trade-off between the level of retirement income, longevity and likelihood of achieving that income?

John Maher
June 30, 2013

Chris, like you I agree that the use of the word "risk" has various connotations. In my case, I had "risk" insurance in the form of Income Protection when at age 42 I was seriously injured in a fatal car crash and was told I would never work again, and consequently I spent 16 years receiving IP benefits.

My investments were sold off and I thank God that "risk" was part of my portfolio.

Thankfully 6 years ago I began public speaking and no longer rely on my Income Protection payments, and I speak on "RISK", specifically the importance of Income Protection.

Yes "risk" can form many parts of a statement or meaning, but when I had my car crash, the "risk" portion of my portfolio saved us financially.

I also speak at secondary schools on Road Safety and the 'RiSK" that our young drivers face on the roads.

Scott Barlow
June 30, 2013

If you consider that the ‘risk’ of any investment is essentially the difference between what return was expected and what return was achieved then distinguishing between the size of risk between different investment portfolios for someone saving for retirement, means the expected standard deviation of the portfolio is the most suitable measure of the "risk" of investment returns.

To quote Rob Arnott the risk that is most important to all of us is “...whichever one hurts us, which cannot be known until after the fact.”

For retirement savers, the risk that would hurt the most is failure to achieve their savings goal and objective and/or the risk of outliving their retirement savings. It is not the year-to-year volatility of investment returns as measured by standard deviation.

Thus the point of using standard deviation is not that it measures the risk of outliving retirement savings (for example) but that it is a lever that can be adjusted and used by astute Financial Planners to manage the risk of their client outliving retirement savings (or missing investment goals).

The use of standard deviation as a measure of portfolio risk is as old as Modern Portfolio Theory itself. And yet to date, the investment management industry has yet to agree on a standardised way of estimating the standard deviations and correlations of asset classes that are to be used by retirement savers to calculate the standard deviations of their portfolios!

The problem is that if different sets of standard deviation assumptions were used by different industry participants then this would lead to confusion by consumers. For example, if one product provider were to declare that their Fund (portfolio) has a standard deviation of say 9%, then another product provider might declare that their competitor is misleading consumers because according to their asset class assumptions that same portfolio has a standard deviation of 11%. It would be difficult to determine who is right.

To avoid the problems of lack of comparability between products (Funds) managed by different providers, a standard set of assumptions should be adopted across the industry that allows ready comparison between different products on the same basis.

It is for this reason that the concept of the SRA number has been developed by my colleagues in the development of our risk-targeting provide a measurement framework that can be adopted by Financial Planners to verify any multi-asset class portfolio on an ongoing basis.

The use of standard deviation in the SRA framework has the advantage that it counts all risks in a portfolio in a single unambiguous measure.

To make this easy for Planners we have developed a web-based Tool that allows Financial Planners to efficiently aggregate the portfolios of multiple managers and direct investments (in standard asset classes) to arrive at a single unambiguous measure for the total risk in their client’s portfolios.

In addition, Planners input their client's current financial situation (account balance, salary, contributions etc) plus all of the client's retirement goals and objectives (weddings, travel, aged/health care costs, sale of business/property/other assets, etc) and the Tool identifies exactly how much risk the client needs to take to achieve thir goals. (Not the risk they are comfortable taking, which is all risk profiling questionnaires do...but the risk they NEED to take!)

It then shows the Planner how to spread the total risk over the life of the client's investing, and dials the risk down such that when the client has the most amount to lose and the least amount of time to recover in the event of a set-back...they are taking the least amount of risk.

Instead of buying and holding their asset allocation, the planners ensures the client buys and holds the risk path. When they do that, they give themselves the greatest chance of achieving their goals and objectives.

Peter Hecht
June 28, 2013

I agree entirely with Chris' article.
Furthermore risk is not a constant. It is a constantly moving feast. Whilst timing of markets is difficult, it is incumbent on a good adviser to be able to assess the risks.

I am 84 and still working full time as a planner. Because of my age, all my qualifications were out of date. I have been resitting many exams of late to ensure I comply with ASIC regulations. Not one question on assessing risk or on how to evaluate the true worth of a managed fund or a share.

Chris Sozou
June 28, 2013


A great article. I too share your frustration at the disconnect between the industry's use of the term risk and the way in which customers perceive risk. I particularly hate when investment managers mis-quote relative risk as an absolute risk, as they do with tracking error (whoever invented tracking error should be shot).

Customer centricity is a buzz word at the moment across many industries, and definately in the finance industry. However, it is just that, a buzz word, with plenty of talk and not much substance. I believe that this lies at the core of what your article is about, that is, we need to put the customer in the centre of what we do, and design outcomes that deliver to their expectations (and where their expectations are unrealistic, guide them with education tools to more realistic expectations).

We can still use our volatility measures, information ratios, sharpe ratios, standard deviations, tracking errors etc as factors in our thinking, but we should always bring it back to the question "how do any of these help me as 'service provider' meet the needs of my client?'


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