We need to talk about risk

"Parable of the Talents
The "Parable of the Talents", in Matthew 25:14–30 tells of a master who was leaving his house to travel, and, before leaving, entrusted his property to his servants. According to the abilities of each man, one servant received five talents, the second had received two, and the third received only one. The property entrusted to the three servants was worth 8 talents, where a talent was a significant amount of money. Upon returning home, after a long absence, the master asks his three servants for an account of the talents he entrusted to them. The first and the second servants explain that they each put their talents to work, and have doubled the value of the property with which they were entrusted; each servant was rewarded:
The third servant, however, had merely hidden his talent, burying it in the ground, and was punished by his master:"
This all boils down to the risk taking ability or risk aversion of different people.....and has evidently been a characteristic of humans since at least Biblical times.
Different people given the same facts reach different conclusions , so I think a "general rule" can never provide a specific
solution to this "risk problem"....and I don't think you can "legislate it away" either !
Personally , the LESS INTERFERENCE with INDIVIDUALS the better. So...some will lose...BUT perhaps the LESSON LEARNT
will be far more rewarding for the individual in his ongoing life than some form of ENFORCED PROTECTION "saving him from the consequences he richly deserves" ? I do NOT think BIG GOVERNMENT and SUPERVISION are needed or desirable.

Interesting use of the parable. I guess it does show that there have always been various attitudes to risk. However, I'd suggest that the parable doesn't stop there. It's main point was that the one who chose not to do anything with what he'd been given was morally and spiritually bankrupt. So it's not really about validating all and every personal choice about what risks to take.
In the end, the parable isn't really about risk taking, but about character - and in particular about attitude to the one who has given the talents in the first place (ie it's about faith and God). To the extent that it says anything about the topic that Chris has written about (and 7 years ago, I note - this is not a current article!), to me it says that a fund manager needs to deliver the risk taking that the investors in the fund expect. So you don't hold all cash in a share fund, for instance, unless you've been very clear in your PDS that you will speculate on the market in that way.

As a former minor federal politician I found the Cuffe comment & other contributions a valuable aspirational reminder of intent & reality - particularly relating to lawmakers. Lawmakers can only ever be a FAQ representative cross section of the "risk" contributors to national outcomes. The current crop are pretty much on L plates and only ever on P plates.
My guideline on lawmakers focus on their honesty & candour record balance by their self interest & survival instincts.
Finally we all need to try and accept that less than 0.01% of us ever contemplate and attempt a federal political role, possibly mainly due to our individual attitude to "risk". My wife & I risked $50,000 to pursue my responsibility to ..." offer rather than whinge"... and to our amazement our offer was accepted five times.
Please consider offering, but be careful your offer maybe accepted!

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

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....

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'!

Thanks for this great article and comments.

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.

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 got...is 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.

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!

Cheers,

David

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?

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.

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 portfolios...to 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 importantly...it 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.

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,

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?'