Managing the risk of being wrong

“Accordingly, investment risk must therefore be defined as the risk of permanent loss of capital. This consideration of investment risk is critical when looking at portfolio performance relative to a market index or benchmark,” says Nick Curtin, investor relationship manager at Foord Asset Management.

“While the approach is understandable, the analysis is one dimensional: Almost all widely used market indices are compiled using a free-float market capitalisation weighting methodology. This means that companies with very large market caps will have large weights in the market index. The construction of such indices considers only a company’s size and not the risk of permanent loss associated with an investment in that company.”

Managing the unpredictable

It is a truism that not every investment idea will pan out exactly as expected — unforeseen situations can arise that fundamentally change a company’s prospects and/or valuation. In addition, the fund manager often gets their investment thesis wrong for any number of reasons.

By successfully managing the risk of being wrong, it’s possible to mitigate the risk of permanent capital loss. As a result, it has been possible over longer time periods to generate returns that are significantly in excess of a market index constructed without reference to investment risk, Curtin explains.

“The primary mechanism is through diversification. For example, an unexpectedly sudden rise in interest rates would be negative for retail companies but would benefit the banking sector in the short term as a result of the endowment effect.

There are many other examples covering variables such as inflation, exchange rates, commodity prices, investor sentiment, economic activity, and the interplay or correlation of such factors with each other. By making sure there are enough diverse drivers of return in the portfolio, a manager can ensure a reasonable outcome, even in those instances when the base investment case turns out to be wrong.”

Position size

“The second key aspect is a constituent of diversification, namely position size,” says Curtin. “Clearly, the potential impact on the total portfolio resulting from a single investment going wrong is directly proportional to the relative size of that investment in the total portfolio.

So it stands to reason to avoid any single position get too big in the portfolio to manage the risk of permanent loss. That said, the more conviction there is in an investment idea, the less diversification needed, so a portfolio can tolerate fewer stocks of larger position size. Indeed, holding too many stocks in a portfolio has been referred to as ‘diworsification’.”

Comparing apples with pears

Elroy Dimson, a professor at the London Business School, said, “Risk means more things can happen than will happen.” Just because a risk does not eventuate does not mean it was not there and should not have been considered and mitigated, warns Curtin.

“While we cannot control the outcome of events, we can arrange our affairs in such a way that we survive intact should the worst transpire. The typical twin-engine airliner can still take off, fly and land if one engine fails — that is an example of very practical risk management.”

Curtin concludes that while most investors are single-mindedly obsessed with performance relative to the index, this is in truth a one-dimensional assessment. “When comparing the portfolio to the index portfolio from an investment risk perspective, it is like comparing apples and pears. However, in the long term the application of sound judgment to portfolio weights while ignoring the index weights results in significantly better performance with lower risk of loss.”