03 May 2020

The risk of risk measures in a Covid-19 world

Mark Henson

Wealth Manager, Investec Wealth & Investment

The Covid-19 pandemic and the effect of the lockdown remind us of how we should be looking at risk.

I doubt there are many out there who would argue with me that investing is a long-term process, with the objective of improving or maintaining one's lifestyle into the future, or to benefit future generations. Why is it then that is when risk is measured relative to long-term rewards, we too often measure it in the short-term way? This is a question I have asked myself many times in the past, and yet the answer still remains fuzzy. 


Equities (investing in listed shares on a stock market) are regarded as the most risky asset class, and cash is considered the least risky. The minimum hurdle rate one should be looking to achieve through an investment portfolio in the long run is to returns net of fees and taxes, in excess of inflation, in order to protect your purchasing power. Inflation is defined as the consistent increase in prices over time and is the “hidden coronavirus” in financial terms that could ultimately cause devastation. 


In my opinion, we need to flip our measure of risk on its head and see cash as the most risky asset class, and equities as the safest asset class in the long run. But before continuing, let me define a few concepts.


 

Defining risk

20%
deviation to R12 million

A google search of the word “risk” tells us that risk is the deviation from an expected outcome at some point in the future. There are a couple of things that stand out for me in this definition of risk. For one, it tells us that it relates to the future, rather than the present or the past. Furthermore, there is confirmation that there is an expected outcome present in the mind, and the risk is represented in terms of the deviations around this future expected outcome. As a result, greater deviation means increased risk.


Now the deviation could be positive or negative and just the fact that there is a deviation should not be assumed to be negative in itself. If I look ahead to the future and hope to retire with a capital pot of R10 million, a 20% deviation to R12 million is a good thing. Deviation does not equal negative or downward outcomes. To determine one's attitude to risk, or one’s risk appetite, is no simple task. It can change over time given a range of influences, including past experience, the external environment, and perceptions for the future.  


According to Investopedia, risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some, or all, of an original investment.


A fundamental concept in finance is the relationship between risk and return. The greater the level of risk an investor is willing to take, the greater the potential return (in the long run). Risks need to be managed and cannot be avoided. Holding everything in cash in a bank account or under the mattress also comes with risks. There are good risks and bad risks, and in the investment context, you should be looking to skew the probabilities so far as possible in favour of your desired outcome at some point in the future.

Systematic vs unsystematic risk

Every investment action involves risks and returns. In general, financial theory classifies investment risks affecting asset values into two categories: systematic risk and unsystematic risk. Broadly speaking, investors are exposed to both forms of risk.


Systematic risks, also known as market risks, are risks that can affect an entire economic market or a large percentage of the total market. Market risk is the risk of losing the value of your investments due to factors such as political risk and macroeconomic risk, which affect the performance of the overall market. The impact of oil price wars and Covid-19 are examples of this. The response by the authorities has been to manage short-term challenges through quantitative easing and fiscal stimulus – both of which could bring new risks in the longer term. Market risks cannot be easily mitigated through portfolio diversification. Other common types of systematic risk can include interest rate risk, inflation risk, currency risk, liquidity risk, country risk, and sociopolitical risk.


Unsystematic risk, also known as specific risk or idiosyncratic risk, is a category of risk that only affects an industry or a particular company. Unsystematic risk is the risk of losing an investment due to a company or industry-specific hazard. Examples include a change in management, management fraud, a product recall, a regulatory change that could drive down company sales, or a new competitor in the marketplace with the potential to take away market share from a company. Investors often use diversification to manage unsystematic risk by investing in a variety of assets.

Not as efficient as we think

Efficient financial markets are less efficient than we think, often driven by inefficient artificial intelligence and algorithmic models, as well as by irrational human investors such as you and me. Whether it is models built by humans, or humans themselves, there are a number of biases at play in the markets. As humans, we are all wired differently based on our experiences, and therefore you may be more inclined to possess an optimism bias or a pessimism bias. I'm not suggesting that you should try and change these inherent biases, but we should be on the lookout to recognise our particular bias and the influence this has on our actions, or lack thereof.


Transparency in the financial world is seen as a positive, and to a large extent I would be inclined to agree with this. Access to information however in the context of a volatile financial world that we've experienced in the last number of weeks can drive investors to behaviour which can encourage short-termism, which in turn may compromise long-term investment objectives.


A number of financial markets around the globe lost over 30% in value in the space of less than a month during March 2020. This created a lot of nervousness for investors, many of whom may have considered, or even worse, followed through by liquidating parts or all of their portfolios. How might this irrationality be extended if there was a mark-to-market or daily pricing model for our primary residence or business? It is possible that for many people, their homes would have lost similar values to listed equity markets over this time, and yet I don't believe people are considering selling their primary residence as a result. On the contrary, investors would probably be inclined to buy good assets when they are priced at a 30% discount.

Financial markets and the real world

As a similar principle to the above, investors would do well to distinguish between the real world and financial markets. Investors should prepare themselves for economic data and bad news over the coming weeks and months, the likes of which some will never have been seen before. Local GDP growth data for Q2 2020 is expected to come out at negative 12%, year-on-year (-37% on quarter-on-quarter, seasonally adjusted and annualised basis), according to Investec's economics team, while the US is likely to see similar declines, according to a recent report by the Congressional Budget Office. However, there is not necessarily a direct correlation between economic data and financial markets, in that financial markets typically look six to nine months ahead, whereas economic data reflects what has already happened. Markets do react to economic data.


The one behaviourial bias I've witnessed over time throughout my career in financial services, which has been particularly relevant during this crisis and in previous market crashes, is that investors look to avoid risk while sitting on cash from the sidelines. This in-action is an action in itself and carries inherent risks of its own. 


The most effective way to manage investment risk is through regular risk assessment, diversification, and regular consultation with a suitably qualified financial physician who can assist in mitigating influences from financial decisions. 


These are unprecedented times and several new records have been set recently in financial markets, mostly for the wrong reasons. It is particularly relevant at times like this that you consult your financial psychologist, also known as your wealth manager or investment manager at Investec Wealth & Investment.

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