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Risk's Wake-Up Call

Investors can take precautions, but at some point, they need to realize that no one can predict the future.

Hal Ratner, 04/22/2013

Risks always have been part of the investing equation, but the shock of the 2008 financial crisis was a wake-up call for many investors who assumed that modern financial markets had been built to prevent such deep drop-offs. In fact, what are rarer in the history of markets are long periods of calm. As investors have come to grips with this reality, they are seeking ways to moderate the effects of the meltdowns of the future. But are investors thinking about risk in the right ways? Is it even possible, or advisable, to try to build a portfolio that can withstand whatever bad event will next hit the markets? To discuss these issues and others, we invited two professional investors who think about risk every day to discuss their views.

Joseph Davis, who has a Ph.D. in economics, is the head of the Vanguard Investment Strategy Group. Dennis Stattman, CFA, managing director and portfolio manager, is the leader of BlackRock’s Global Allocation team. Our conversation took place Feb. 26 and has been edited for clarity and length.

Hal Ratner: I’d like to start off our conversation by getting from both of you a definition of risk and how it should be viewed in an investment framework.

Dennis Stattman: The most important things that I can say about risk are that it’s key to look at it from a number of different perspectives, to look at a lot of measures, and then also to look at risk qualitatively. In the Global Allocation fund MDLOX and on the Global Allocation team, we never lose sight of the idea of risk as being the chance of permanent loss of capital, because that’s ultimately what most investors are worried about. It’s always at the forefront of our minds.

Ultimately, risk is about client objectives; it’s important to see risk from the clients’ point of view. What’s their motivation for investing in a particular portfolio? And what could happen that would lead to a failure of that portfolio to live up to their objectives and expectations? So, that’s the context in which we need to be thinking about risk. It has to be in relation to clients’ objectives and expectations for a particular portfolio.

We always look at risk in the context of a variety of measures. It’s been popular in our industry for a long time to use mean-variance analysis, and in fact, we use that, as well. But we don’t think of risk as just being variance, or volatility, or beta, or standard deviation, or tracking error. We don’t think of it as being any single measure. We look at a lot of different measures.

We also try to look at risk in qualitative terms. We are value-oriented investors, and we think price matters a great deal. We think that if you do a good job of identifying value that you’re actually lowering the risk of the portfolio in two particular ways. One of them is building an asymmetry of return, meaning more upside than downside. The second is building in the characteristic that time is on the investor’s side.

So, if one has identified an undervalued security, it will tend to accrete value faster than the market. That puts time on your side. If you believe in your analysis, then it puts the psychological staying power on your side, to both hold through periods of volatility and even perhaps increase position size if a period of volatility has lowered prices. That allows one to take advantage of volatility rather than being driven by it. We think that’s particularly important because volatility and implied volatility, while they’re very popular measures of risk, tend to behave somewhat perversely, in that actual volatility and implied volatility are very often inversely related to price. In other words, if price has gone down a whole lot, then volatility and implied volatility tend to be high. That’s just exactly the opposite of the intuition that we might want to have in most circumstances, which says when prices are low, you want to increase your risk-taking, as opposed to reduce your risk-taking. So, blind adherence to volatility can put one in a position of disadvantage in market dynamics.

Hal Ratner is the chief investment officer, Europe, with the Morningstar Investment Management division.

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