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30 Sep 2015

UNDERSTANDING INVESTMENT RISK

Regulators have increasingly focused on the protection of retail investors in financial products during the last decade. Industry practice in disclosing the risk profile of investment products, in our view incorrectly, promotes a system that classifies risk according to equity weighting. Thus, portfolios with a low allocation to share markets are “low risk,” while portfolios with a higher equity allocation are classified as “high risk.” WILLIAM FRASER unpacks investment risk.

Such a risk classification system can only be justified by equating short-term variability of returns – volatility – with investment risk. It is common knowledge that share market volatility, when measured over short time horizons, is greater than the volatility of asset classes such as cash or bonds where interest or coupon payments comprise a greater percentage of total returns. This leads to the incorrect and financially damaging assumption that portfolios with greater short-term variability in returns are riskier investment propositions.

This system ignores the investment objective of the portfolio, the expected duration of the investment, the investment philosophy of the investment managers and their past success in achieving the objective. Many of these more important measures of investment risk require more in-depth knowledge of investment managers and their track records. This requires significant management time and due diligence. The resultant risk assessments, however, have very little to do with equity weighting in portfolios.

Foord has always classified investment risk as the risk of permanent loss of capital. Increased volatility does not cause permanent loss of capital and therefore is not an appropriate measure of investment risk. Examples of permanent loss of capital include corporate failures leading to bankruptcy, massively dilutive rights issues (companies issuing new shares), sovereign and corporate bond defaults, bank failures or the purchase of investments (shares, bonds, property or commodities) at excessive valuations where the earnings never materialise and share prices subsequently fall.

Investment risk can be significantly reduced by avoiding investments with an elevated probability of permanent capital impairment. This concept of investment risk applies to all investments, not only share investments. Accordingly, equating investment risk to equity weighting is misconceived and detrimental to the long-term savings objectives of investors.

This brings us to current market conditions. Those investors who closely follow markets have undoubtedly noticed a marked increase in the daily movements of individual share prices and market indices. This is very different from the prior post Global Financial Crisis of 2008 / 2009 where share prices increased reasonably smoothly.

The longer a certain trend is intact, the more certain we can be of a change in direction of share prices. Near zero percent interest rates and excess global liquidity have caused a period of stable but rising share prices. The paucity of attractive investment opportunities in other asset classes has constrained investors to equities, further elevating the market rating.

As we approach the end of near zero percent US interest rates, some investors are choosing to exit share markets. Less resilient shareholders typically sell at any price when volatility levels become too uncomfortable. They may question their actions and change their decision a number of times. This leads to prices rising and falling, with greater undulations between decisions, and volatility increases. During these periods, investors with longer time horizons and greater tolerance for volatility get the opportunity to purchase great companies at much reduced prices.

This increased volatility is not necessarily a measure of increased risk of loss, but an indication of the increasing uncertainty of stock market investors. The continuous postponement of an interest rate increase in the United States is mainly to blame for this uncertainty. Market participants have been expecting an interest rate rise this year and this information has been priced into share markets. Recent developments and September's decision not to raise rates have caused market participants to doubt their conviction.

The volatility issue aside, it should also be noted that the rise in market multiples and the poor investment climate in a growing number of sectors is simultaneously increasing investment risk (that is, the risk of permanent loss of capital). So we are experiencing elevated investment risk at the same time as elevated volatility. Distinguishing between risk and opportunity takes both skill and experience, supported by rigorous investment research.

Thankfully, the portfolio managers at Foord have investment experience ranging from 10 years to 35 years and most have experienced at least three full investment cycles. The portfolio managers' experience, the rigour of the research supporting the purchase of quality companies, the diversification of the aggregate portfolio, the conviction behind the portfolio construction and, most importantly, the courage to remain invested for the long term are the safety mechanisms provided to investors in professionally-managed portfolios.

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