Howard Marks, from Oaktree Capital, sums up the risk situation very well:
“One way to think about risk is to consider the (twin risks) that investors face every day: The risk of losing money and the risk of missing opportunity. The balance between offense and defense. In theory, you can eliminate either, but not both. Moreover, eliminating one exposes you entirely to the other. Thus, we tend to compromise or balance the two risks, and every individual investor should develop a view as to what their normal balance between the two should be.”
Although Marks sums up the situation well, there are more risks to consider than just these two.
Different types of risk:
1. Volatility risk
Most people perceive risk as the possibility or probability of their portfolio declining in value. What can add to an investor’s anxiety is the volatility that the portfolio endures over time, in order to achieve a specific outcome. This risk becomes very real when a detailed needs analysis has not been performed or the client insists on a mandate that’s not actually suited to their situation.
This risk can be mitigated easily by ensuring that the correct mandate is in place. Mandates that expose your capital to higher degrees of equity exposure will certainly be more volatile, and therefore by definition riskier, than ones with less equity.
Mandates with higher equity exposure therefore need longer periods over which to measure their success. Taking this into account, for clients with high equity exposure, short to medium term volatility should not be considered a risk.
2. Inflation risk
Here, the risk is that inflation erodes the value of your retirement capital more quickly than you anticipated. A common mistake is for an investor to take stock of their portfolio and simply do a calculation as follows:
“My R5 000 000 investment portfolio is invested in a fixed income fund, which returns approximately 8.0% per annum, yielding me R400 000 per annum or approximately R34 000 per month. This is sufficient for my needs."
What’s not being taken into account is the current and future levels of inflation and the fact that the inflation rate will devalue the capital value annually. Therefore, not only is the capital value declining in real terms, but the future income requirement is increasing over time, in line with inflation. The problem with this risk is that by the time it’s been identified, it’s often too late to remedy.
The mitigation of this risk can be done by constructing an appropriate portfolio pre and post retirement.
3. Permanent loss of capital
If an inappropriate higher-risk mandate is selected for a client, this can lead to permanent capital loss.
For example, if a client insists on a high-risk portfolio in order to attempt outsized returns, quickly, this can lead to vast fluctuations in the capital value of the portfolio. If this coincides with a down-turning market, the investor can become panicked and make irrational investment decisions at the worst possible time. Realising these losses by reducing equity exposure in the market trough, can lead to permanent loss of capital.
It’s often perceived that high-risk and high return go hand in hand. However, this is not always the case. Taking on more risk is a strategy that can lead to higher returns but time in the market is required, not trying to time it!
The other way in which a permanent loss of capital can occur is by investing in entities that are highly geared(they contain a lot of debt) or risky single stock investments that end up as failed business ventures.
The above risks can be mitigated by clear communication when drawing up the mandate, diversification of exposure and prudence by both parties.
4. Sequencing of return risk
This risk occurs when the client needs to withdraw capital from a portfolio on a regular basis and this coincides with a bear market and/or periods of prolonged underperformance by the fund manager (according to their respective benchmark).
In this scenario, a client would need to sell down investments while they are declining materially, in order to fund the withdrawals. This is not a desirable scenario.
This risk is mitigated by making use of a bucket strategy and/or ensuring sufficient income is being produced in the portfolio for reinvestment opportunities.
5. Incorrect mandate selection
Although not an exact science, it’s important to get the Big-Picture right.
Errors arise when a mandate is selected that is vastly different to the one that is appropriate for the client.
By way of an example, a mandate is adopted that’s more conservative than needed and inflation erodes the value over time resulting a insufficient capital at later stages of retirement.
Or a mandate is adopted that is more aggressive than you need. This happens when people choose to risk what they need in order to gain something they merely want.
Through a proper needs analysis this risk can be mitigated.
6. Liquidity risk
This risk arises when you need your capital for a specific unforeseen event, but you’re unable to access it due to the structure of the investment.
For example, you might commit a large sum of your net worth to an endowment policy, to reduce your tax, but then suddenly require this capital for an unexpected event.
Or you might commit too much money to a retirement annuity over a period and then suddenly require a portion of that capital for a down payment on an investment property.
This risk is mitigated by proper planning with your financial advisor or investment manager and clear communication on withdrawal restrictions.
7. Underperformance of an investment manager
This is a very real risk and can occur when an investment manager under performs his/her peer group over a prolonged period of time.
The Association of Savings and Investments in South Africa (ASISA) allocates funds into specific risk categories. The risk arises when an investment manager underperforms, repeatedly, within their respective category.
It’s natural for a manager to both under and outperform during certain business cycles. The under performance only becomes a problem when it becomes structural in nature regardless of business cycles.
This risk is mitigated by blending managers together to smooth the alpha generation.