Guide to Investment Strategy

1

Setting the scene: What is risk for a personal investor?

Think about risk before it hits you

Risk is about bad outcomes, and a bad outcome that might arrive at a bad time is especially damaging and requires particularly attractive rewards to compensate for facing that risk. Investors and their advisers have typically judged the riskiness of an investment by its volatility, but in the words of Antti Ilmanen, author of Expected Returns: An Investor’s Guide to Harvesting Market Rewards, not all volatilities are equal, and the timing of bad outcomes matters for risk as much as the scale of those bad outcomes. A theme throughout this book is that investors should think about how investments might perform in bad times as the key to understanding how much risk they are taking. There is little discussion of what constitutes a bad time, which will vary from investor to investor, but it is best captured by Ilmanen, who defines it as a time when an extra dollar of ready cash feels especially valuable.

What constitutes a bad outcome is far from simple. It is typically specific to each investor. Thus, a bad outcome can vary from one investor to another and from investment to investment. If an investor is saving for a pension, or to pay off a mortgage, or to fund a child’s education, the bad outcome that matters is the risk of a shortfall from the investment objective. This is different from the risk of a negative return. In Chapter 6, the distinction is drawn between threats to future income (which is of concern to a pensioner) and threats to the value of investments (which matter to a cautious short-term investor). This indicates that the short-term risk of losing money is inadequate as a general measure of risk.

As mentioned earlier, there is a temporal dimension to risk. In practical terms, this means that a multi-period strategy gives multiple opportunities to review the strategy as time passes. Thus risk is also about the chance of anything happening before the investment matures, which undermines an investor’s confidence in the future objective of the investment being met.

To complicate matters, there is a distinction between risk and uncertainty. Gambling on tossing a fair coin constitutes risk as the outcomes and their probabilities are fully known, even though the actual result of the coin toss is not. Being hit by meteorites, abducted by aliens, and other such phenomena, while tossing the coin, brings a different dimension to the situation as we cannot fully describe the outcomes or their probabilities. The latter concept is referred to as uncertainty.

Financial decisions are a mix of risk and uncertainty. In 2017, we were in a world of low financial risk and high political uncertainty. It is clear that this uncertainty will also vary among individuals. Since those working in the investment business are uncertain about market relationships, it is reasonable for investors to be at least as uncertain. It is also reasonable for their confidence to be shaken by disappointing developments along the way, even if those developments are not surprising to a quantitative analyst.

Investors’ expectations are naturally updated as time evolves and as their own experience (and everyone else’s) grows. As far as the investor is concerned, the perceived risk of a bad outcome will be increased by disappointments before the target date is reached, undermining confidence in the investment strategy.

The pattern of investment returns along the way matters to investors, not just the final return at some target date in the future. This focus on the risk of suffering unacceptable losses at any stage before an investor’s target date has highlighted the dangers of mismeasuring risk. An investor might accept some low probability of a particular bad outcome occurring after, say, three years. However, the likelihood of that poor threshold being breached at some stage before the end of the three years will be much higher than the investor might expect. The danger is that the investor’s attention and judgment are initially drawn only to the complete three-year period. As the period is extended, the risk of experiencing particularly poor interim results, at some time, can increase dramatically.

The insights from behavioural finance (see Chapter 2) on investor loss aversion are particularly important here. Disappointing performance disproportionately undermines investor confidence. The risk of this, and its repercussions for the likelihood of achieving longer-term objectives, represents issues that investors need to discuss regularly with their advisers, especially when they are considering moving to a higher-risk strategy.

Research findings from behavioural finance emphasise that investors often attach different importance to achieving different goals. The risk of bad outcomes should be reduced, as far as possible, for objectives that the investor regards as most critical to achieve, and, ideally, any high risk of missing objectives should be focused on the nice-to-have but dispensable targets. Investors may then be less likely to react adversely to the disappointments that inevitably accompany risk-based strategies. They will know that such targets are less critical objectives.

Risk is about the chance of disappointing outcomes. Risk can be managed, but disappointing outcomes cannot, and surprising things sometimes do happen. However, measuring the volatility of investment performance, as a check on what the statistical models say is likely, can be helpful in coming to an independent assessment of risk. But it will always be based on a small sample of data. Thus we can attempt to measure the risks we perceive. Uncertainties that exist but that we neither have the imagination nor the data to measure will always escape our metrics. There are no easy solutions to the problem of measuring uncertainty. This led Glynn Holton to write in the Financial Analysts Journal in 2004: “It is meaningless to ask if a risk metric captures risk. Instead, ask if it is useful.” It is worth commenting that the availability of more and better data, which is a strong feature of modern finance, does mean that some of yesterday’s uncertainties may become tomorrow’s risks.

More often than not, the real problem is that unusual risk-taking is rewarded rather than penalised. There are numerous investment strategies with names like Low Volatility, or Low Beta, that appear to have lower-than-market risk but higher-than-market returns (see Chapter 7). Two points can be made about this. First, we may not be measuring risk correctly. Second, we need to avoid drawing the wrong conclusions about the good times as well as the bad times. This theme is captured by a photograph at the front of Frank Sortino and Stephen Satchell’s book Managing Downside Risk in Financial Markets. It shows Karen Sortino on safari in Africa, petting an intimidating rhino. The caption underneath reads: “Just because you got away with it, doesn’t mean you didn’t take any risk.”

Fraud and betrayal