www.wealthandfinance-news.com 22 Wealth & Finance International - Issue 3 - 2018 The world’s second highest mountain, K2, is famous among the mountaineering fraternity for being the most likely to kill you. More than one climber in every four that reaches the summit is dead before they get home. The right preparation and equipment may well reduce your chance of dying – but few would deny that climbing K2 carries a risk that goes off the scale. But what is risk? And when do we know when something is simply too risky? The honest response to these questions is that ‘it depends’. While some activities, and indeed some investment opportunities, can reasonably be considered as inherently risky, risk is different for everyone. We each have different levels of income and savings, different life aspirations – and different tolerances to what we perceive individually as “risk”. What is risk? Risk, in its broadest form, and with particular reference to investing, is the relationship between the financial loss you could potentially face against the gain you could possibly make. It is often the case, where an investment has a perceived higher risk, that there is a potential for greater returns than when an investment has a perceived lower risk. To put it simply, if you put your money into a particular investment, what is the likelihood of you losing some or all of it? And what is the potential reward? The vast majority of investors will, understandably, weigh up the risk to their capital at the same time as considering the potential reward they could receive for that level of risk. Is the risk worth the potential reward – for that individual? Each individual (both the individual making the investment and the individual creating the investment solution) will have different behavioural biases, different life experiences and different investment experiences, along with a different knowledge of investment and risk. All of this means is that there can never be a single answer that is suitable and appropriate for everyone. Using our everyday life examples, an Olympic road race cyclist, with their fitness, experience and superior equipment, would probably view their daily ride to work as being far less risky than the rest of us. A professional powerlifter’s view of heavy objects will also differ to most people’s…you get the picture! Inexorable truths There are some basic investment truths when talking about risk and reward that need to be understood before any sort of ‘risk assessment’ of an investment can take place: 1. There is no such thing as ‘no risk’. Everything has risk. The assessment is about how much risk you want to take for the potential reward, and NOT whether you want to take some risk or no risk. 2. There is an inseparable relationship between the level of risk being taken and the reward that may potentially be received. 3. There are numerous different types of risk that should be considered when making an investment decision and it’s important to be aware of what these are and how they could potentially affect the overall return you may receive. These different risks include: market risk, equity risk, interest rate risk, liquidity risk, inflation risk, longevity risk, timing risk, volatility risk and social, political or legislative risk. The list goes on. The problem for any investor is that it is virtually impossible to compute all potential outcomes when there are so many unknown – and uncontrollable - factors involved. With this in mind, the familiar warning that accompanies most legitimate investment opportunities – that “past performance is not necessarily a guide to future performance…”- is almost as obvious as the packet of peanuts that declares “may contain nuts”. To give some assistance, some investments have ‘scores’- normally on a range of say 1 to 10, where 1 is low risk and 10 is high risk. These risk ‘scores’ mainly consider the level of potential reward and the possible loss, and they are assessed by volatility or standard deviation. The problem here is that volatility is not the only measure of risk! Let’s Talk About Risk Risk is everywhere in our lives. Cycling to work, lifting a heavy object or simply getting out of bed all have their elements of risk. We still do these everyday things, but we normally take reasonable steps to minimise any risks. Martin Vaughan, Senior Partner of Clear Capital Management LLP, explores how learning lessons from our everyday life can teach us a great deal about risk in terms of financial investments. FI170020 Company: Clear Capital Management LLP Contact: Martin Vaughan Contact Email:
[email protected] Address: 35 New Bridge Street, London, EC4V 6BW, UK Phone: 020 3011 5200 Website: www.clearcm.co.uk There are also other ways to mitigate risk, and we use these strategies within our own model investment portfolios. Using the example of K2, we at Clear Capital Management LLP, see ourselves as the experienced mountain guide. We not only have the crampons, the ice picks and the oxygen, we know the mountain’s climate very well, we know the quicker and riskier ascents as well as the slower, less risky ones. Relating this back to investments, we create solutions that will help our financial advisers access the most appropriate, properly managed choices for their clients. For our individual clients, we will assess your own experience and fitness levels before you even set foot on the mountain – and, importantly, we will advise you not to proceed if we do not feel you are capable of returning home safely. Lastly, we will also tell you that there is most definitely a risk involved – and don’t believe anyone who tells you otherwise.