Business:In any investment, risk is inherent. Even the most considered risk-free investment avenue of sovereign bonds or Government bonds/Gilts also carry a risk of default i.e. default of countries/governments not honouring the commitment which we’ve witnessed post the global financial meltdown of 2008. So, that puts virtually no investment that is risk-free or no-risk.
In this context, no investor could avoid or evade the risk, but their advisor could certainly contain or mitigate the risk. Risk management hence is the key for successful investing and the subsequent return generation. Thus, return generation is a bye-product of risk management.
Though of high importance, risk management is more often misunderstood and wrongly conceived while designing or constructing portfolios. One should acknowledge that money not lost is money earned i.e. avoiding a loss is making a profit over the same reference.
Risk management involves in bringing consistency by identifying, evaluating and mitigating the risk in an investment or in a portfolio of investments. If risk is not managed well it could lead to failing slow, failing fast or failing very fast as described by Justin Sibears of Newfound Research. Let me explain a bit about these.
Failing slow happens when the portfolio returns are insufficient to generate growth needed to meet one’s objectives. This is not due to a specific event or news related, but it slowly builds over time similar to that of a house being destroyed by termites.
In the investment context, if one is too cautious and oversized or non-optimal allocations towards cash, would result in not only generating returns but also exposes the portfolio to inflationary risk. This is witnessed especially during the accumulation phase and corrective measures could be taken to increase exposure to higher risk investments to cover the gap. This move could backfire, if the timing is not apt.
Failing fast is a divergent outcome when a portfolio realizes large losses at wrong time. Continuing the earlier house analogy, it’s equal to the house being destroyed by a hurricane instead of termites. This is a sequence risk and is severe during a distribution phase or consumption of the accumulated corpus i.e. during the annuity period of a retirement fund.
A consequence of sequence risk is that asset classes or strategies with strong risk-adjusted returns, particularly of those that are able to avoid large losses, can produce better outcomes than investments that may outperform them on a pure return basis.
Failing really fast as the phrase says is more of an adjective and an enhancement of the situation of failing fast.
Market crashes are part & parcel of the system and are a reality of investing. However, as a famous saying goes: it’s not news but how humans respond to news, compounds the situations. So, these human reactions or errors that turn bad situations into real disasters. The errors could be due to failure to adequately prepare ahead of time and poor decisions in the heat of the moment.
Ultimately, risk management is not about risk avoidance or risk reduction but about taking the right quantum of risk. Aaron Brown summed this idea up nicely in his book Red Blooded Risk, where he wrote, “Taking less risk than optimal is not safer; it just locks in a worse outcome.
Taking more risk than is optimal also results in a worse outcome, and often leads to complete disaster.” One of the better ways to achieve this is to have a tactical asset allocation over a strategic asset allocation.The latter is arrived after proper risk analysis of the individual considering his timelines, cash flows and goals while the former is like making most of the opportunities available at any given instance.
The hallmark of a robust risk management strategy is to not simply minimize risk but align both the investment objectives with that of the market environment.(The author is co-founder of ‘Wealocity’, a wealth management firm, and could be reached at email@example.com)