Risk management is a serious business for all players in the financial world. Asset managers’ finest minds and heaviest computing power are devoted to looking at events and scenarios from the point of view of likelihood and seriousness.
Like everything in investing, there’s a quantitative and qualitative approach, matching up the art of prediction with the science of investing.
The two biggest global events in the last two years have been the pandemic and Russia’s invasion of Ukraine. The pandemic seemed more unexpected, but the risk of a global health scare has been discussed for decades, it's just that Western governments chose to downplay the warnings from scientists. Likewise, Putin’s move was unexpected but not beyond the realms of comprehension for military strategists.
Hindsight is a wonderful thing.
Both events will affect ordinary people for years, and feel like “fork in the road” moments. But they also matter for investors. Both triggered a sell-off in “risk” assets, one of which was severe, the other less dramatic.
(Risk assets are generally meant to encompass those that are volatile, rely on positive news about the world and the economy, but can make your money disappear when things go badly.)
Risk is the likelihood that something could go wrong.
It is a measurement of how likely it is that a bad outcome will occur.
From an investment point of view, risk may seem a trivial concept by comparison, but as investors we face risks all the time. It is just that it seems somewhat more acceptable. Companies, traders, and private investors, take risks all the time, because there is simply no reward without it.
A few years ago, advisers were cautioned by the Financial Conduct Authority, the conduct regulator for around 50,000 financial services firms and financial markets in the UK, to make sure their clients understood the risk of losing money on their investments, and how this would affect their financial plans. A discussion subsequently emerged about capacity for loss, and the extent to which people like you might be too dependent on dangerous investments.
There’s a spectrum here. At the most extreme, bad investments in companies that go bust, or scams, risk money disappearing. Long-term risks, however, might be stocks or funds falling short of what you want or need, leading to a poor or unhappy retirement. Alternatively, you may take too little risk and regret it when it's too late to do anything about it. The results of not taking risk are also a risk.
Risk is deeply personal, and very specific.
When you drive a car, there is the risk of injury or death. Fortunately, modern technology has reduced that risk. On a construction site, the risk of serious head injury increases when you don’t wear a helmet. Ukrainians (and Russian soldiers) face the risk of loss of life.
During the pandemic, businesses of all shapes and sizes faced what felt like a new risk, and the personal suddenly became dramatically economic.
There is the risk of inflation; when our investments don’t keep pace with prices, nobody really wins.
If you’re a big spender on food, and food prices are stubbornly high, will you be more exposed? Undoubtedly.
If you’re staying in a posh locality, and rents keep increasing, will it hit you financially? Of course.
If you happen to be poorly diversified when the ship sinks, will the pain be greater? Inevitably.
While the above has been written by JAMES GARD and OLLIE SMITH, senior editor and editor, Morningstar UK, BEN JOHNSON, head of client solutions for Morningstar, has something to add to this conversation.
How investors experience and respond to risk will vary depending on personality, circumstances, and experience.
Some people are wired to seek out risk, be it in the markets or by jumping out of an airplane. Others much prefer to play it safe, with their feet firmly on the ground. Then there are the skydivers who keep their cash under a mattress and the actuaries who like to bet on the ponies after work. The point is: Risk is personal.
Investors’ circumstances also affect their willingness and ability to take risk. Investors who have accumulated substantial financial assets likely have a greater ability to take risk, but they may wish to preserve their capital and, thus, be less willing to assume more risk. People in their twenties have ample ability to take chances, given that they likely have decades to save and invest before they retire. Investors nearing retirement may have relatively less ability to take risk as they transition from accumulating financial assets to relying on them for retirement spending.
Investors’ experience will also influence their relationship with risk. People who have lost vast sums in the market in the past may be uneasy about taking risk in the future. Serial entrepreneurs may be more comfortable with risk than company men and women. Investors’ risk appetite may fluctuate with the market and evolve over time. Ask on December 31, 2019, years into a bull market, during a period of relative calm, to rate my willingness to take risk, and I’ll tell you I’m happy to pour it on. Ask me again three months later at the depths of the coronavirus-driven selloff, and I’d probably be a bit less cavalier. Our attitudes toward risk are always changing.
When it comes to risk, look at your mindset and what is within your power. Focus on what you can control.
Larissa Fernand is an Investment Specialist and Senior Editor at Morningstar India. You can follow her on Twitter
