Being compensated for taking risk is the foundation of investing — but that idea is being challenged more and more every day as expected returns on risky-asset classes continue to fall.
We know that exposing our assets to risk is necessary to earn the return required to meet the objectives of the investment portfolio. But are Committees and Boards ensuring compensation for exposing the assets to various risks is appropriate?
The challenge in answering this question is compounded by the need to define what risk means to begin with. In the investing world, measures of volatility in realized returns, such as standard deviation, are often used to describe risk. The efficient use of that risk is measured by relating it to the return generated through ratios such as the Sharpe or Sortino Ratios.
Committees and Boards will review the portfolio results on a periodic basis and view standard deviation in an ex-post sense – in other words, after the fact. In uneventful periods, especially over the last five years or so, this backward-looking number can mask true risk and give the appearance of being well compensated risk for the investment portfolio over that period.
In a few week’s time, you will likely be receiving your Q3 performance report and will likely notice a standard deviation number that is similar to last quarter’s. I wonder, what would have happened to the investment portfolio if North Korea did indeed launch a missile at Guam in August, for instance?
Looking solely at the performance report, one would likely conclude that there is no heightened risk to the investment portfolio at all as the measure of risk remains low. Do you agree?
For institutional investors, risk can simply be defined as the inability to fulfill the promise the assets are earmarked for – pension benefits, health and welfare benefits, endowment spending, or anything else.
For the beneficiary, the risk tolerance is zero: s/he is relying on the money being there when it’s needed. As the fiduciary of their capital, decision makers must view risk in an ex-ante manner, ensure risk is compensated, and understand that we don’t know what we don’t know.
The people of Texas and Florida know full well that hurricanes happen – they know what the risks are, just not which hurricane season will launch a storm in their direction.
As investors, we know the path to success is not linear and that it can be very long, causing us to become complacent. When the storm inevitably comes our way, it does so without warning and it can be relentless.
In both instances, too much optimism and too little preparation ultimately have devastating results.
In that spirit, spreading out the sources of risk, or diversifying, is by far the most effective tool to mitigate risk. Peter Bernstein famously said, “diversification is the only logical deployment of our ignorance”. As a side note, Bernstein was an American financial historian, economist and educator whose development and refinement of the efficient-market hypothesis made him one of the country’s best known authorities in popularizing and presenting investment economics to the general public.
This concept can be misconstrued as exposing your assets to as many different risks as possible, which often leads to “di-worse-ifcation” of risks without compensation – risks that could hinder an investor’s ability to its objectives.
That doesn’t mean diversification at any cost, but I wouldn’t advise building a beach home and not buying hurricane insurance.
Lewis Powell is a consultant at Proteus.