 Tim Cockerill, Head of Collective Investment, Rowan Dartington
Are you a risk taker? Would you go bungee jumping or parachuting, horse riding or take part in a contact sport? In these instances risk is physical and easy to quantify – minor cuts and bruises or the odd strain; although the worst case could be far more serious.
When it comes to investment, risk can be complex, multi-faceted and hard to quantify. Yet itcomes in two basic forms– firstly the risk that your chosen investment will underperform or even become worthless and secondly the wider risk attached to being in the market place, but with both of these there are a multitude of factors that influence risk. Whilst individual investment risk can be mitigated by thorough research and can be diversified away (to a degree) by holding a spread of investments, the wider risk of the market place is unavoidable once the decision has been made to invest. Then there’s possibly the hardest part, assessing a client’s risk appetite.
Client risk assessment is at the centre of the FSA’s current focus and rightly so. This is to ensure that client risk appetites and their portfolios are aligned, so that the expectations of client’s are met. There continues to be a lot of debate about risk assessment and how to arrive at the ideal measure of an individual’s risk profile. Yet it’s hard to see this debate being resolved to the point where everyone agrees, because risk is personal, it changes over time,with experience and as an individual’s financial situation changes.
It is therefore critical in managing portfolios to monitor, manage and continually assess risks and changes in client risk profiles.At Rowan Dartington risk management is a critical component in portfolio construction and monitoring. The starting point is the clients risk appetite - once established this determines their exposure to certain levels of investment risk, the combination of which meets with their overall risk profile. This ensures their portfolio is managed within anappropriate risk range. This range allows flexibility to take advantage of improving or deteriorating market conditions driven by risk assessment of asset classes, macro-economics and so on.
In practical terms we assign a risk rating (1-5) to all investments, 1 being the lowest. These ratings are arrived at by analysing a combination of factors, both quantitative and qualitative.
‘Quantitative assessment can help to identify consistency in an investment, alpha added by managers, correlation to markets, volatility etc. This helps to highlight risk and consequently categorisation into our 1-5 ratings. Qualitative measurement is subjective and relies primarily on experience to make assessments and yet is probably the best insight into investment risk, however combining them gives the best of both worlds’.
This approach enables us to produce a risk score for every portfolio and to see if it is within the clients risk tolerance. Although this may seem simplistic there is a significant benefit because it creates a starting point framework. We can then compare the asset allocation of the portfoliowith centralised portfolio frameworks and adjustments made where needed.
Macro-economic analysis drives asset allocation and it is this assessment of the opportunities and risks that shape portfolios. In this process we are looking to identify emerging risks but equally emerging opportunities too. Risk and opportunity are two sides of the same coin!
At this point we know that a client’s portfolio has the correct risk profile and asset allocation. Risk and opportunity is then assessed at the geographic level, again driven from the central portfolio framework and for those portfolios which invest in direct equities another layer of risk assessment is applied to ensure that individual stocks and sector exposure is within centrally set tolerances. The monitoring of all these factors allows portfolios to be managed anticipating changes in risk and opportunity.
Whilst it is not possible to foresee or quantify all risks it is possible to understand the majority of risks inherent within an individual investment or portfolio. It is then possible to build a portfolio with the appropriate risk profile for different circumstances, objectives and time horizons. There is always the potential for unexpected risk but by definition these events cannot be prepared for!
There’s no doubt risk is centre stage at the moment and avoidance of it, but it should also be remembered that taking too little risk within an investment portfolio can in itself be a risk. For example - if inflation runs at 3.5% for ten years an investment of £10,000 needs to grow to £14,106 to be worth the same in ten year’s. An overly defensive investment strategy for fear of capital loss could easily see the real value of the investment eroded.
Managing risk, measuring risk and spotting emerging risk is ever developing and changing. In order to measure risk historic data has to be used but this can’t accurately predict the future as the recent events have shown. Over reliance on this data leaves investors vulnerable, so a qualitative approach is also an essential ingredient in my view. And it is the qualitative assessment of risk that is most likely to identify new emerging risks, but this is not easy. How do you realistically assess the impact of future political statements regarding the Euro for example? You can’t! But what you can do is manage risk at as many levels as possible to capture, assess and mitigate risk to the degree suitable for every client portfolio you manage.
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