Risk is a very broad concept. From an investment perspective, you could look at it as the possibility that actual returns differ from expected returns. This ties into the concept of risk being seen as uncertainty. Higher risk tells us there is greater uncertainty in return outcomes.
Risk is a very broad concept. From an investment perspective, you could look at it as the possibility that actual returns differ from expected returns. This ties into the concept of risk being seen as uncertainty. Higher risk tells us there is greater uncertainty in return outcomes.
In the investment industry, volatility is commonly used as a proxy for risk — where volatility is the degree of variability in the returns of an asset or portfolio over time. Volatility is measured by annualised standard deviation, typically using monthly returns. A larger standard deviation reflects a larger variation in returns, which implies higher risk.
Sounds simple, or is it?
In this article we explore the many dimensions of investment risk, highlighting how risk is not an absolute concept but one shaped by statistics, psychology and context. While volatility is used as a proxy for risk, it only captures part of the story. Risk also involves the subjective manner in which investors perceive uncertainty and more importantly, loss. Risk needs to be understood through multiple lenses to make better investment decisions.
Caveats to using standard deviation
There are considerations one needs to be cognisant of when using standard deviation as a proxy for risk:
1. Standard deviation does not distinguish between upside and downside, and investors only fear downside.
2. Whilst the formula for standard deviation does not require data to be normally distributed, financial returns often exhibit skewness and heavy tails. Because standard deviation measures average dispersion around the mean, it may fail to capture the likelihood and impact of extreme market moves.
3. Since this is a backward-looking exercise, it may not tell us anything about the future. Yet, history often provides the most practical starting point for anticipating the future.
Point one is quite intriguing and opens some interesting concepts, which we will cover later in the article. Focusing on point 2, Nassim Nicholas Taleb1 has written books to emphasize this point and argues that volatility is an inadequate measure in the real world.
So, do we throw the baby out with the bathwater? Not necessarily. Whilst volatility may not be an all-encompassing measure for risk, it is a decent indicator for uncertainty. In addition to volatility there are multiple risk metrics that measure the different angles to risk including potential big losses, downside-only risk, tail risk etc. It is probably best to look at multiple risk metrics to get a fuller appreciation of risk.
That being said, we land at point three. Many risk metrics are built using historical data and hence are backward-looking, which can be misleading when regimes change. In practice, one can combine historical data with forward-looking scenario analysis to get a more comprehensive assessment of risk. Without the benefit of hindsight or foresight, assessing risk will always remain an exercise, useful but never absolute.
Risk becomes more subjective
Coming back to point one, this ventures down the alley of behavioural finance. Many traditional economic and financial theories rest upon the assumption of investors behaving rationally. A rational investor is one that uses logic and reason to process all information available, weighing up risks and rewards as they make decisions to maximise their expected utility. But what if investors are not rational?
Daniel Kahneman and Amos Tversky2 put forward an alternative framework — known as Prospect Theory — as a critique to expected utility theory. Their theory demonstrates that people weigh losses more heavily than gains and, in that scenario, often refuse fair bets. This is due to the sadness of losing R1 being felt more strongly than the happiness of gaining R1. This concept, known as loss aversion, highlights that the direction of change (be it a gain or a loss) matters a great deal. Risk becomes more about the chance of losing money, as well as the fear and regret that accompany loss.
The birth of neuroeconomics in the late 1990s brought experiments that combined economic games with brain imaging. These showed that decision-making regarding risk is not a simple calculation but is entangled with the emotional centers of the brain. The amygdala, also known as the brain’s fear centre, has been identified as a key player in loss aversion.
With this lens, risk becomes more subjective and is influenced by beliefs, feelings, experiences and social context. It also highlights the divergence between risk appetite and risk capacity.
Equating risk with volatility is therefore, not necessarily the whole picture. Interestingly, some of the methods of dealing with loss aversion involve framing discussions around potential losses so that the focus shifts toward the long-term probability of meeting goals rather than short-term setbacks. Some financial institutions have even developed products with builtin downside protection, which limits losses at the expense of some upside. This highlights that there are multiple ways to approach risk management, and more importantly, there is no free lunch with any one choice.
Biases in risk perception
Kahneman and Tversky, along with other authors, highlight several behavioural biases and heuristics in risk assessment that tend to distort investors’ judgement of risk. These may include:
When biases lower perceived risk, investors are prone to take on more risk and vice versa. Essentially, they can lead to misperceptions of investment risk and sub-optimal decision making.
How we manage investment risk
Investment risk management is an integral part of our investment process and we believe there are multiple components to investment risk management. The more familiar component is linked to constructing and managing our portfolios, which we will address shortly. The other one is related more holistically to how we run our business. We believe it is important to build and maintain a strong investment team, where decision making is shared. Additionally, having the right systems in place to run our investments is vital. These considerations, amongst many others, form the foundation upon which we carry out our investment function.
Turning attention to our investment function, we decompose investment risk into two sources: (1) our investment philosophy and process, and (2) underlying investment risk. The first source is extensive but can be broadly classified under the functional structure of our investment team and the investment process. These areas include manager research, asset allocation, portfolio construction, and portfolio management.
The second source, underlying manager risk, involves managing active risk. We view this as the risk of performing differently to a benchmark — be it underperformance or outperformance. This is like volatility, which measures uncertainty both to the upside and downside.
When an underlying manager underperforms, our process is designed to understand the source of that underperformance and whether it is to be expected given the manager’s approach and the market environment. Underperformance is not necessarily seen as a trigger to fire a manager.
Overall, we believe risk should be measured in multiple ways and to meet the objectives of clients, we ensure that we take an appropriate amount of market risk over relevant time horizons.
Conclusion
Perceptions of risk vary significantly among different investors. What one person sees as a high-risk investment, another might view as a valuable opportunity, depending on their individual circumstances, experiences, risk tolerance, and investment goals. There is risk in everything we do - from eating a chocolate bar to taking a step out of the door. Yet, we do not stop doing these things because of the risks. We acknowledge them, including the expectation of that chocolate bar releasing endorphins, serotonin, and dopamine, which makes us feel good.
Ultimately, understanding that risk is subjective can help investors to make more informed decisions and develop strategies that align with their unique perspectives and goals.