Portfolio Risk Measurement

chiang_mai

aroominyork said:

chiang_mai said:

My bonds are all short duration, this part is very clean.

Short duration bonds are of course less volatile than intermediates through less interest rate sensitivity, but in normal market conditions you have less of the inverse correlation which can reduce overall portfolio risk during an equity crash. Do you only hold govt bonds or also corporates?

I am tilted towards short duration, mostly for high yields (which tend to be short) and for gilts I might want to cash in if there is a prolonged equity crash. (I also hold a short duration strategic bond fund, just because I think it is well managed.) I still have a chunk of intermediate gilt/global aggregate index funds.

I'm holding Artemis short duration, Prem Mitton Strategic and PIMCO GIS low duration. I also hold the bond elements of a couple of MA funds and these are typically Gilts or US Treasuries. 

chiang_mai

Linton said:

masonic said:

My preference is to hold the defensive assets separately, either direct holdings (e.g. individual gilts) or dedicated bond funds, although something down at ~20% equities is sufficiently bond-like to be considered a bond fund. I don't pay much attention to broad ratings, but if there were an equity fund that tended only to fall 10% to the market's 20%, that would be an attractive proposition. What I've found though is that diversification is the volatility reducer, so then a balanced global equities portfolio for the equities bucket is tough to better. For all the talk of managers who can skilfully limit drawdowns in a bear market, I've not seen evidence this can be done reliably without substituting other asset classes.

Value weighted and income equity funds seem to  reduce volatility (as measured by Standard Deviation) to some extent. Whether this is the same as reducing “risk” may be arguable. ISTM  that “risk” needs to be defined more precisely to be a useful concept.

I've been working at trying to define the risk of loss inherent within my holdings and conclude it's a many headed beast. Inappropriate asset allocation is a risk that I've finally nailed, ditto capitalisation, sector, drawdown, volatility and concentration risks also. In fact I think I've covered all the aspects that I am able to, with the exception of individual fund risk that is subject to market movements or contagion. As an earlier poster pointed out, holding the likes of TSMC in several funds (which I do) is a risk, ditto being overweight financial services in the UK and Europe (which I am). But at some point a risk becomes something that has to be accepted, if you're going to hold a particular fund, as such it can't be mitigated. The biggest risk for me is the risk that I haven't identified. If I've identified the risk and done nothing about it, that means by default that I've accepted it.

MA260

Apart from the usual sectors and markets , does anyone consider currency movement risks, for example if GBP strengthened a lot then it would be detrimental to many overseas funds.   

chiang_mai

MA260 said:

Apart from the usual sectors and markets , does anyone consider currency movement risks, for example if GBP strengthened a lot then it would be detrimental to many overseas funds.   

I consider currency risk and typically ensure any fund that I buy is denominated in GBP, or hedged back to GBP. I consider the possibility of sustained GBP strengthening to be the type of risk that doesn't need to be addressed soon.

chiang_mai

Some practical examples (and solutions)

I tried to decide between Orbis Cautious and Orbis Balanced, two very similar funds where the Balanced fund contains more higher risk equities than the Cautious fund, including TSMC. The difference between the two is ten points on the MS scale, one is rated Moderate and the other Adventurous. In practical terms it's the difference between 44% and 76% equities, a drawdown of 2.1 vs 1.5 and volatility of 8 vs 5. I eventually decided that the risk in both funds was acceptable so I split my investment between the two.

Where I had great difficulty is in deciding how to manage European equities. I started with Artemis SG Europe, switched to a lower risk Europe wide tracker but have now gone back to Artemis. The problem with the Artemis fund is concentration in Financial Services, which at 38 is very high. That said, the upside capture rate is 119 whilst the loss on the downside is almost zero! Since the risk is proprtional to the size of the investment, the mitigation was to accept the risk but to reduce my investment in the fund to where the impact of any potential future loss is also reduced. 

I use the L&G US Index to manage my investment in US equities, the drawdown is 17 and the Standard Deviation is 19. It helps me to remember thos enmumbers because that's the price you haveto pay for investing in over 500 companies in the worlds largest investment market, it helps put other funds risk into perspective.    

aroominyork

The four Ts of risk management are: 
- terminate, ie stop doing the activity
- transfer, ie take out insurance
- treat, ie take action to mitigate the risk
- tolerate, ie there is no mitigation available so accept the risk and continue the activity. 
Your approach seems to be a lot of treat with a little tolerate. The problem is that the four Ts are based on identifying possible risks, assessing the likelihood of each one happening and the severity of impact if it does, and then deciding what to do about it. Our problem in investing is that we do not know the nature of the next risk; who thought Russia would invade Ukraine leading to commodity supply side challenges? So we tend to cut straight to 'treat' using the single tool of diversification, without knowing whether it is the right tool for the job. It's an imperfect system but, without a crystal ball to see what the world will throw at us, it's pretty much all we have. 

chiang_mai

aroominyork said:

The four Ts of risk management are: 
- terminate, ie stop doing the activity
- transfer, ie take out insurance
- treat, ie take action to mitigate the risk
- tolerate, ie there is no mitigation available so accept the risk and continue the activity. 
Your approach seems to be a lot of treat with a little tolerate. The problem is that the four Ts are based on identifying possible risks, assessing the likelihood of each one happening and the severity of impact if it does, and then deciding what to do about it. Our problem in investing is that we do not know the nature of the next risk; who thought Russia would invade Ukraine leading to commodity supply side challenges? So we tend to cut straight to 'treat' using the single tool of diversification, without knowing whether it is the right tool for the job. It's an imperfect system but, without a crystal ball to see what the world will throw at us, it's pretty much all we have. 

The first and most important step in my world is identifcation and recognition of the risks, I don't think that hope and blind faith are very good allies when markets become volatile. To do that you have to look inside the fund from a number of different angles and also look at historic data. I hear the argument about the usefullness of historic data but past performance and composition data is one of the few objective tools available to us. They say that past performance is not a reliable guide to the future, but show me an investor who says they do not consider historic performance figures in some way and I'll show you someone who is being economical with the truth!   

I also don't think it's enough to rely on the fact that a fund is classed as say cautious or moderate risk, I think it's important to understand why and how that is so. Different fund rating systems see some funds in different ways. The other important step is to try and quantify the risk using whatever systems of measurement you can find. If you haven't done those things, how can you possibly know how to derisk or when you've reached a level of risk that is acceptable or reasonable. 

aroominyork

You say “The first and most important step… is… identifcation and recognition of the risks… To do that you have to look inside the fund from a number of different angles…” 

I would say you are not assessing risk – you are assessing a fund’s past volatility and, so far as you can tell without knowing the future, its potential for future volatility. When a KIID scores a ‘risk and reward profile’ on a 1-7 scale, it is using ‘risk’ as a proxy for ‘volatility’ because it’s the best measure we have. Indeed, a KIID says “This indicator reflects the volatility of the fund's share price over the last five years which in turn reflects the volatility of the underlying assets in which the fund invests.” 

To me, it is more useful for risk to refer to external issues (geo-political etc.) which can affect the market; volatility is internal to the fund and can be measured by looking under the hood of the fund. You can, of course, hold a whole load of volatile funds which are perfectly inversely correlated with each other to create a low volatility portfolio… though whether it will work in practice depends on what the world throws at us – the unknowable, though sometimes partly guessable, external risks.

chiang_mai

aroominyork said:

You say “The first and most important step… is… identifcation and recognition of the risks… To do that you have to look inside the fund from a number of different angles…” 

I would say you are not assessing risk – you are assessing a fund’s past volatility and, so far as you can tell without knowing the future, its potential for future volatility. When a KIID scores a ‘risk and reward profile’ on a 1-7 scale, it is using ‘risk’ as a proxy for ‘volatility’ because it’s the best measure we have. Indeed, a KIID says “This indicator reflects the volatility of the fund's share price over the last five years which in turn reflects the volatility of the underlying assets in which the fund invests.” 

To me, it is more useful for risk to refer to external issues (geo-political etc.) which can affect the market; volatility is internal to the fund and can be measured by looking under the hood of the fund. You can, of course, hold a whole load of volatile funds which are perfectly inversely correlated with each other to create a low volatility portfolio… though whether it will work in practice depends on what the world throws at us – the unknowable, though sometimes partly guessable, external risks.

"I would say you are not assessing risk – you are assessing a fund’s past volatility and, so far as you can tell without knowing the future, its potential for future volatility".

Before I even get to that point, the internals of a fund that I want to understand include the capitalisation ratio's, sector balances, geographic spread, etc etc etc. Those things have the potential to be sources of risk that I don't want. For example, I don't want to hold more than 10% small caps and I don't want concentration in a small number of sectors, and so on. 

Assessing past volatility is a downstream step and whilst not a perfect guide to the future, I'll take it as an reasoanble approximation over several years. I think you then have to marry the emerging picture with your assessement of the geo political, current and future probable to see how it stacks up. Do I think that holding TSMC is high risk, in light of the mainland threat? No I don't, but I do think that holding too much of any one stock in a variety pf places, is high risk, regardless of who or where they are.

I think we are saying similar things. There is a need to assess internal and external factors in order to understand the risk profile of your investment and understanding just one of them, doesn't mitigate risk or maske it more acceptable. 

aroominyork

We're mostly making the same point. I'm just highlighting that as much as you can have the perfect inversely correlated low risk portfolio, you don't know what the world will throw at you and whether it'll sink like a stone.