Gareth Morgan looks at how risk should be handled in your investment portfolio. Do you agree?

By Gareth Morgan*

This is the second of four articles on investment performance, where we will now look at risk.

Too many investors don't take a blind bit of notice of risk.

In my first article I identified four pillars of investment performance: returns, volatility, liquidity, and the chance of catastrophic wealth destruction.

The first of the four is what you want to get, the other three all relate to the risks you take in chasing those returns. Sadly too many investors don't take a blind bit of notice of risk.

At the heart of measuring investment performance is measuring the return relative to the risk of the investment.

Investors are often seduced into higher returning assets without being aware of, or even considering, the risks involved. This is a recipe for wealth destruction.

If we're talking about your life savings the objective should be to increase its value, but subject to not losing it. This is an incredibly important qualification.

Catastrophic risk

In this article I focus on the volatility of returns, but before doing so I want to discuss catastrophic risk - the chance of losing the lot.

The collapse of so many finance companies in New Zealand over the past five years is a tragic reminder of the devastation that can be inflicted on people's wealth by catastrophic risk.

Catastrophic risk can befall an investment irrespective of a history of low volatility of returns or a history of satisfactory liquidity.

Things can change suddenly. An asset can fall victim to adverse events that quickly destroy its value. Catastrophic risk is the extreme of volatility, but historical data provides us with no basis to judge the chances of it happening.

Most fund managers minimise catastrophic risk by capping the exposure to any one security, sector, asset class and country in the portfolio and so if disaster strikes (BP's Deepwater Horizon oil spill in 2010), only a limited portion of the portfolio is affected. This is neatly captured in the old adage of not having all your eggs in one basket. In investment parlance we call it diversification.

It's important that investors can see and understand whether their investments are spread across a lot of assets or just a handful - could they stand the shock of one asset going belly up?

Volatility

To understand volatility, you first must understand that there are two parts to the return you receive on your investments: the expected return and the unexpected return.

We tend to invest on the basis of the expected return. But we always invest with uncertainty and depending on the extent of that, the unexpected component of your investment return is, by definition, more random and often outweighs expected returns.

For a bank term deposit the unexpected component is more or less zero - you will be paid a specific rate of interest for the term of the deposit, nothing more and nothing less.

But for a share the unexpected return can be quite large. Share prices do not go up steadily; they can swing wildly up and down for no apparent reason.

The point of measuring volatility is to try to gauge what the unexpected return component on your investment portfolio might be.

A portfolio with higher volatility will have larger swings in value over time due to chance, and - this is the important bit - a rational investor should demand a higher return for having to tolerate that volatility.

This is the crux of measuring investment performance: it's not just the return you receive, but the degree of certainty of that return.

With an investment portfolio the return you receive is important but the reliability of that return also matters. When investment performance is fully considered - return relative to risk - a rational investor will select the manager that is most likely to provide the higher risk-adjusted returns; that is, returns that have more dependence on the expected rather than the unexpected component of the return.

Let's look at a comparison of KiwiSaver fund volatility to illustrate the risk and return. It's not that easy to get the required data for KiwiSaver schemes, therefore the results in the graph below should be treated as indicative rather than definitive. The data comes from scheme websites and in some cases Fundsource, and the returns data are net of most fees but before tax has been deducted.

This graph shows volatility graphed against returns for six large KiwiSaver Balanced funds.

Funds that are the bottom right quadrant are performing poorly and those that are in the top left have, over the period of the graph, performed relatively well.

The graph is a meaningful investment performance comparison subject to the limitations of the returns data and the additional limitation on past volatility as a representation of risk - it's only an approximation of what even volatility might be in future. It shows annualised returns relative to annualised volatility.

In pushing for better reporting of investment performance by KiwiSaver schemes the government needs to make sure schemes provide sufficient detail for investors and commentators to present accurate and comparable risk adjusted returns. In short, greater transparency from providers is required.

There is one other important consideration that is often overlooked: the ride matters.

It's hard for investors to stomach large fluctuations (losses) that come with a volatile portfolio and during market falls investors often decrease their allocation to volatile assets, locking in their losses. Likewise when returns are high, investors have a tendency to allocate their funds to higher volatility assets - investors confuse the expected return component with the unexpected return received, and as a result they go beyond their risk tolerance - they get greedy! It's a challenge to remain disciplined and pursue high quality returns (high risk adjusted returns, not just high returns).

In summary, there are two parts to the return you receive on your investments; there is the expected return and there is the unexpected return.

The point of measuring volatility is to try to gauge the unexpected return on your investment portfolio.

This is the crux of measuring investment performance: it's not just the return you receive, but the certainty of that return - a high return does not necessarily mean the investment was a good one.

If the goal is to select the best investment manager a rational investor will select the manager providing higher risk adjusted returns (all else being equal).

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Gareth Morgan is a director of Gareth Morgan Investments. Any opinions expressed in this column are personal views and are not made on behalf of Gareth Morgan Investments. This article was first published in the NZ Herald. It is used here with permission.

The first article in this series is here »