Risk Profiling, Risk Management and Investments

 
by Eben Maré, Head of Fixed Income, ABSA Asset Management

IBM recently estimated that we generate approximately 2.5 quintillion bytes of data daily (one followed by 18 zeros – roughly the equivalent of 57.5 billion 32GB iPads). 

The flow of information has had a profound impact on the financial markets and investors’ attitudes. Consider the following two statements:

1.  “Our favourite holding period is forever.” – Warren Buffet.
   
   
2. According to the NYSE factbook, in the 1960s stock average holding periods amounted to around eight years – currently it is believed to be of the order of several days.
   
   

There are several interpretations one can draw from these two statements.

1. Buffet’s quote refers to investment conviction and ignoring short-term ‘noise’.
   
   
2. The NYSE factbook statement, however, is about flow of information, uncertainty, short-term goals, liquidity and changes in the investment landscape and investors’ attitudes to bearing longer-term risks.
   
   

Modern investors undoubtedly face a proliferation of investment products and ideas. However, they also benefit from the diversification afforded by liquidity in international stock, bond, currency, and commodity markets as well as the access thereto.

The flow of information serves to create liquidity in the financial markets – one could argue, however, that investors are prone to misinterpretation of information and the likely effects of current events on long-term investment outcomes. Take as an example the amount of confusion and anxiety that has arisen as a result of the so-called Brexit decision. 

Another example would be the effects of zero and negative interest rate policies (so-called ZIRP and NIRP, respectively) currently maintained by many central banks – how are investors to calculate the long-term effects of policies which have served to elevate asset price valuations without delivering meaningful extra economic growth? 

The effect of longer-term trends

Policies are one source of uncertainty but it is equally important to try to understand the effect of longer-term trends; interest rate curves are presently low in many parts of the world, this is partly reflective of low interest rate policies maintained by many central banks as referred to above, however, investor confidence and limited profitable opportunities have kept the so-called equilibrium real interest rate subdued.

[[[PAGE]]]

Investors have an acute desire for returns; they do, however, suffer from a lack of understanding risk (or more appropriately, risk management). At its core, modern portfolio theory, which embraces the concept of diversification, is a statement about return and risk. 

The problem with ‘risk’ is that we frequently reduce our explanations to investors into a one-dimensional variable, to wit, volatility. Risk is multi-dimensional:

1. Investment risk is about understanding investment outcomes – this is a statement about the distribution of prospective returns.
   
   
2. Risk is about the quantum of losses experienced (or that could be experienced).
   
   
3. Investment risk is path-dependent, i.e., investors will (subconsciously at the very least) determine their returns periodically and assess future returns relative to this new baseline.
   
   

At its core, though, risk management constitutes a process. The risk process typically starts by understanding the asset risks we hold (e.g., equities or bonds) as well as the ‘liability’ risks we have (such as our investment objectives). The next step requires an understanding of the risk in financial terms. This requires an understanding of the distribution of the investment’s returns. We would typically try to assess the extent of our losses if the investment turns sour. We want to limit our potential losses and would typically determine the allocation of our investments to minimise the risk of such losses. The next step in the risk process is to evaluate investment outcomes periodically to ensure that the process works.

Risk profiling

Risk profiling is the process we follow to ensure we understand a client’s return objectives and the associated risk to achieve those objectives as well as the client’s ability to absorb risk and tolerance for risk. Risk profiling should be done at the onset of the investment process, whereas risk management is an ongoing overall process. It is therefore important to understand that risk profiling is only a part of the risk management process but not sufficient on a standalone basis. 

Risk profiling should enable us to answer the following questions:

1. Do I require capital preservation?
   
   
2. Are my investment objectives in real or nominal terms?
   
   
3. Am I concerned about short-term fluctuations?
   
   
4. Do I require regular income or am I looking at substantial growth?
   
   

Risk profiling is therefore a crucial ingredient of the risk management process. It forms the basic ingredient of our investment appetite; the risk management process, however, ensures our long-term sustainability.

[[[PAGE]]]

The modern environment abounds with information. In many respects we could argue that we are constrained by too much information. The process to construct our investments to attain longer-term financial goals (such as retirement plans) needs to be fundamentally rooted in the principles of risk management. We should understand our means and our goals; we need to ensure we have a thorough understanding of our own risk attitudes and make that an integral part of our investment process. 

Benjamin Franklin said: “An investment in knowledge pays the best interest”. Ensure you understand your investments and how you see your investments – your investment process which includes your own risk profile and risk management process might constitute the best investment you have ever made.

Eben Maré Head of Fixed Income, ABSA Asset Management Eben joined ABSA Asset Management in January 2016 as Head of Fixed Income. His previous role was at Stanlib where he was responsible for managing the Absolute Return investment portfolios for a period of seven years. Eben has held a number of senior trading and management positions in the markets over the last 26 years which included General Manager at Nedcor Investment Bank responsible for domestic treasury activities and all derivatives trading as well as portfolio manager at Genbel Investments. He holds a Ph.D. in Applied Mathematics, does research in his spare time and holds a dual appointment as Associate Professor in the Mathematics and Applied Mathematics department at the University of Pretoria.