Dear Adam,
There seems to be a ton of confusion surrounding risk management, what it is, and what it actually aims to do.
So here goes:
Risk.
Everyone seems to know this word - what it looks like, and how to spell it.
But every time I ask advisors and clients about it, I get the same vague explanations of what risk is, and how risk is managed...
I often hear from investors that they are "not comfortable taking any risk", or that they can "take on more risk". If one of these sounds like you, you may want to read further to learn more about how these would be interpreted by good risk managers.
Here are 5 popular risk quotes, and their common explanations:
High-risk, high reward - If you take on a higher risk, will you get a higher reward
Risk-adjusted returns -A measure of returns based on either the "risk-free rate" and/or standard deviation
Risk tolerance questionnaires -a questionnaire that aims to measure how much risk a client can accept in a portfolio
Risk-free rates - the rate of return you can achieve that is "risk-free"
Risk-averse - a quality of someone who would like to avoid risks
Here's the thing: there are many different types of risks and none of the above explains which type, specifically, we're talking about.
Here are some types of risk you may encounter within an investment portfolio:
Credit Risk - the risk that money you lent will not be paid back.
Liquidity Risk - the risk of not being able to exchange something for money quickly.
Longevity Risk - the risk of outliving your money.
Systematic Market Risk - the ebbs and flows of a publicly valued market due to optimism and pessimism.
Non-Systematic Market Risk - the risk that a single entity will fail (mismanagement, fraud, technological displacement).
Taxation Risk - the risk of giving back some of your efforts to the government.
Concentration Risk - the risk of putting all your eggs into one basket.
Inflation Risk - the risk that your purchasing power will be lower in the future than it is today.
Interest-Rate Risk/Duration Risk - the risk that the going rate for a new loan is more than the existing loan you hold (and hence worth less as an asset).
Currency Risk - the risk that assets held in a different currency than the one you normally transact in fluctuate enough to change the value of an asset.
And probably many more
If we look back at the 5 Risk Quotes we described above - knowing there are many different types of risks (listed above); then what risk type are we talking about when we measure a client's risk tolerance? What risk type are we supposed to take on to achieve a higher reward? What risk type is included in the calculation of "risk-adjusted returns"? What risk type is a risk-averse person trying to avoid?
So, what is Risk Management?
Risk Management is the art of assessing the trade-offs of a potential decision.
Here's a real-life scenario in assessing trade-offs:
Let's say you're in your car, and up ahead at the intersection a hundred metres away, you start to see that red pedestrian hand flashing, indicating that the intersection traffic light (currently green) will be turning red soon. There's a good chance (although not guaranteed) that if you step on the gas a little more, you can make the light.
So, do you step on the gas? Do you try to make the light? Or do you stay the course and guarantee yourself a delay waiting at the red light?
Let's just pause here for a moment and assess the trade-offs of this potential decision:
if you step on the gas and go faster, there is certainly more risk of an accident occurring at a higher speed. There is also the risk of a police officer seeing your actions and penalizing you with a ticket. There is also the risk of not being able to stop in time and running a red light. There is also the risk that all these additional risks taken do not result in any positive outcome whatsoever because there is no guarantee you will even make the light...
Conversely, if you do not speed up right now, you are guaranteed to be sitting impatiently at a red light for over 30 valuable seconds - time you will never get back!
After analyzing the implications of this decision, what is your answer? Should you speed up and try to make the light? Or cruise at your current speed and wait at the intersection's red light?
The answer is: it depends.
We need to delve a little deeper here to find out if this is a good decision or not. We need to also understand the context of the decision, not just the implications of it.
For example, if you have your baby in the back seat and you're simply out to get groceries and not on any sort of timeline, it may be prudent to simply stay at your current speed where you will most certainly be sitting at a red light.
That said, if you are at the risk of being late for a job interview that your professional career depends on, it may be a worthwhile endeavour to step on that gas pedal.
With the same assessment of the implications of this decision, an appropriate recommendation can only be made when it is paired with the scenario objectives and the context.
Risk Management in Investing
Let's examine a similar scenario in the financial world.
A client meets with their financial advisor and tells the advisor "I don't want to take on any risk. I want all my money to be invested in GIC's because I can't afford to take risks".
The advisor ponders for a moment... No risks?? Is there such a thing as not taking any risk? what does this client mean? Where is this coming from?
In my experiences, when a client tells me: "I don't want to take any risk. I want all my money to be invested in GIC's because I can't afford to take risks".
This is what I hear: "I would like to reduce my systematic market risk and my non-systematic market risk down to zero. As a trade-off, I would like to disproportionately increase my inflation risk, my taxation risk, my longevity risk, and my liquidity risk."
Now I pause. Is this a good decision?
The answer (of course) is that it depends on the context of this decision as it pertains to the objectives of this client.
* Assessing the trade-offs of the risks involved alone is not enough information to be able to make an appropriate decision or recommendation. *
Now, if this individual intends to purchase a property in 2 years, investing in GIC's is not the worst decision to make.
However, if this individual intends to grow wealth over the long-term and draw income from it for 30+ years thereafter - this would be a highly inappropriate solution.
So... What is Risk Management, Really?
My view is that Risk Management is the process of assessing the trade-offs of the various options available, having an understanding of the context and the objectives of the scenario in question, and then making an appropriate decision or recommendation based on this information.
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A quick note on concentration risk:
American Economist and Nobel Prize Laureate Dr. Harry Markowitz once said: "Diversification is the only free lunch in investing."
What is meant by this quote is that in investing, you do have the capacity to reduce your concentration risk (see explanation above) without necessarily taking on another risk as a trade-off.
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In conclusion.
There are many risks out there to be aware of. Risk is not something you can lower or take less of, nor is it something you can raise or take more of. Much like energy, risk cannot be reduced or increased, but rather transferred from one type to another. Reducing one of them very likely increases another.
Assessing the trade-offs of risk alone is not enough to make an appropriate decision or recommendation. We also need to understand the context and the objectives of the scenario in question to make an appropriate decision or recommendation.
The take-home here is to ensure you have a framework for long-term investing, and to ensure your emotions (excitement when markets are up, fear when markets are down) don't cloud your judgment in sticking to that framework.
If you have any questions about your financial plan, would like our opinion on what this current financial landscape means for long-term investors, or would like a refresh on the framework we have in place for times like these, please never hesitate to reach out.
We are available and accessible to you any time through email, phone, or video. For additional information, related website links, and upcoming seminars, please visit my website at www.adamschacter.com. Past articles can be found at adamschacter.com/blog-1.
Be well and be safe,
Adam