Each of these chapters are around the same amount of pages…cue heavy sighing.
So what is risk? Apart from a crappy board game it is the concept that for each action there is an inevitable reaction and risk is the chance we run that the reaction will be bad or negative or perceived to be shitty. However you want to colour it, that’s how it is.
For example, I choose to walk across the road without the light. There are a number of reactions, but the end goal is to get to the other side unscathed. The risk is that I may not, because I was hit by a truck, or a giant Hippogriff swooped down to take me off to Hogwarts. That’s the risk I take.
Same if I took 100k and invested it into the stock market in a company. I run the risk of losing every cent. I also run the risk of doubling my money.
At least that’s how I see risk.
According to my little (Read: Insurmountable) book:
Risk is defined as the chance that an unexpected event will cause loss or injury and can be categorised into two different types – pure risk and investment risk.
I like my explanation better.
Pure Risk can be slightly mitigated by insurance but essentially is every day risk. For example, I could have a car accident on the way home and write my car off. The risk is there but slightly mitigated by the fact I have insurance.
Investment Risk is the chance of loss or gain being made.
Investors generally act rationally is a load of horseshit! I work in Investor Relations and I can absolutely attest to that being a steaming pile of horse manure.
Put simply is the method used to determine and Investors highest acceptable level of risk. Basically, you’re not allowed to assume the Investors predisposition to risk. You need to know their goals and fears, time horizon, and also their moral code. For example, would your investor be ok with investing in a company that makes pornographic material, or tobacco and alcohol companies? Yes, this is a thing. Interestingly, this is actually a legislated obligation under the Corporations Act.
This book makes out that Investors aren’t capable and that’s why they need a financial planner, and the financial planner wears the responsibility if something goes wrong. They have to take on almost a psychologist role to cajole and comfort investors. Not the case. That’s bull. If you are investing money, do your own research as well. Arm yourself with the knowledge and don’t be an idiot.
Bell Curves: Hated them in school, still find them thoroughly unattractive.
However, they apply here. So there are seven types of models in Australia and they range from ultra-conservative to super-risky. My words, not theirs. The bell curve applies to how many people are in that model. So models 4 & 5 being in the middle have the most, and then it sort of peters out as you get to the edges. Kind of like the political spectrum. Most people are in the middle with views and then you have the outliers on the fringes. We call them the extremists or fundamentalists. Fiscally speaking a fundamentalist, or super conservative model isn’t going to earn you large sums of money, but its virtually risk free. The Extremists are sitting over there with model seven wearing the most risk but also the higher return potential. So really no one on the outliers are real winners, because of the risk v return factor. Also kind of like politics. The future is in the middle.
Of course people react negatively to a loss. What do you expect? Not everyone understands Capital Gains and Losses. I don’t fully but I get in some portfolios a loss counteracts the gain for tax purposes and this is not a bad thing.
Reviews are also important in this process especially after significant life changes, like marriage, children or divorce.
Horrible little calculation this one. I learn every time I repeat the statistics course at uni, and promptly forget it. Maybe they have an easier way of remembering it. So far, I understand that the higher the Standard Deviation, the higher the risk. Alternatively, the larger the spread of returns, the more volatile the asset is.
Used to measure how similar the return patterns are for two investments. Results come in three forms, Positive, Negative and Independents. Positives have a similar return pattern, Negatives have a dissimilar, Independents are just marching to the beat of their own drum and have no discernible similarity. In other words, the hipsters of the coefficient world.
Interestingly, Negatives give the maximum in diversification and risk reduction. Also Independents give smoother returns for Investors.
Basically the relationship of the investment or portfolio to the market or chosen benchmark. It’s basically the degree in which the investment moves. A Beta of 1 will move parallel with the market whereas a Beta of 2 will double the market movement. The higher the Beta, the higher the risk as well.
The downside to Betas is that they are calculated on historical data so their relevance to the future is a lot less.
Gotta Risk It to get the Biscuit
Limiting risk is what everyone wants to do, but how far can you limit it?
The formula to do this is below:
Looks scary right? It kind of is, but also kind of not if you have all the information to input. There are other, scarier formulas, which you can see here.
Interestingly, having a negative correlation between assets is a good thing. Mainly because it means they won’t be doing the same thing at the same time and so you won’t have super gains or super losses at the same time across the portfolio and will keep the portfolio level.
Didn’t even know this was a thing. Apparently a portfolio is efficient if no other portfolio offers higher expected returns with the same or lessor risk. Seems legit.
Diversifiable Risk and Risk Control:
Diversification of asset classes and is possibly the only risk reduction technique.
We have different versions of Diversifiable Risk:
- Business Risk;
- Liquidity; and
- Credit Risk.
Diversification done well offsets the effects of a single or few poorly performing assets in a portfolio.
Market Risk however cannot be controlled by diversification. For example, the sub-prime crisis in the US was an event that affected the entire market and so everyone felt the pain.
A way of calculating the risk-adjusted return of an asset class is by dividing the annualised excess return by the risk. Also known as the Sharpe Ratio.
Sharpe ratio = (Asset Return − Risk-free rate)/Standard deviation
Pretty simple stuff.
Risk Minimisation and Management Methods:
Where the asset can be split so it can be sold in parcels rather than as a whole asset. For example, units in a trust can be sold according to limits in the PDS, whereas if your asset is a house, you would need to sell the whole asset instead of a portion.
Cash Floats: Basically keeping cash on hand in very liquid stocks or cash itself to cover any short term cash requirement of the investor.
Setting Limits and Return Targets:
Limiting the variables of a portfolio by setting a limit to the total risk the investor is willing to bear.
Basically talking to the investor instead of acting alone.
This chapter was so long and really hard to focus on. We got there in the end. At least Chapter three is less than half the size.