Risk is more than just a four-letter word

There are all sorts of pithy aphorisms about what happens when risk management isn’t taken seriously. The most famous of which is probably Warren Buffett’s line about discovering who is swimming naked when the tide goes out. As is often the case with the Sage of Omaha, there is considerably more wisdom to his statement than one might expect in such few words. I’ve often wondered whether he intended such depth from the quote or whether, as such a prominent personality in investing, we ascribe more to it than intended. In total it is the following thirteen words: ‘Only when the tide goes out do you discover who's been swimming naked’.

This could simply mean that those who mess around doing something they ought not, will be found out eventually. Splashing around in one’s birthday suit might be liberating but could prove embarrassing. Equally, taking risks with a portfolio might appear fruitful for a while but losses are much more painful than gains and foolhardy behaviour can cause considerable pain eventually. The reason for this appears to be that we are hardwired to think in fractions when assessing changes in wealth. A fifty percent gain is not the same as a fifty percent loss because the latter, a halving, is psychologically equivalent to a doubling. In other words, to our minds, a 50% loss is the same as a 100% gain. This makes sense if one remembers what gain is required to offset a loss. On paper a 50% loss and a 67% loss are similar, but the requirement to get back to square one is 100% for a 50% loss and 200% for a 67% loss. That is not a trivial task.

Back to Mr Buffett’s quote. Note, he says ‘discover’, he doesn’t say ‘see’, observe’ or ‘notice’. Whether this was intentional to convey deeper meaning or simply a case of Mr Buffett having a penchant for the poetic is irrelevant. ‘Discover’ implies that you can only see that the swimmer is nude once the tide recedes. Literally, the immodesty is covered by the murky sea water. Here the high tide is equivalent to sanguinity in markets where conditions are benign, with its ebbing to a low tide analogous to a much more serious market where money is being lost. And so, in investment markets, it is fiendishly difficult in reality to simply ‘see’ risky behaviour during steady markets and nigh on impossible during booms. Risky behaviour is masked by the relative opacity caused by rising markets – i.e., it cannot be ‘seen’. Only when markets are not so accommodating do we get to ‘discover’ who is being reckless. It is not that those whose recklessness was uncovered were unlucky: they were being reckless all along.

The problem is that markets are mostly steady or rising. Periods of stress, especially serious systemic stress, are where the big money is lost – but they are very much not the norm. Consequently, two things can happen. Either investors can forget how bad things can get and behave in a manner that they believe to be sound. Or, and this is particularly true of professional investors, risk management can become a burden – inasmuch as caution is not rewarded, since it invariably means not participating in sharply rising markets. Despite the advances the industry has made in the due diligence of investment managers, ultimately performance sells and those without it struggle to do well.

At AJ Bell, we believe in simplicity and transparency, and in the investments business this focus has aided us in building a product set that behaves both in a predictable way, and in a very open and low-cost way. Nevertheless, we take risk management very seriously. It is insufficient to simply create products that adhere to volatility measures because, whilst a crucial component, not all risk can be adequately captured in this way. Some consideration must made of what could happen to upset the status quo. This involves consideration for asymmetry of outcomes where the probability and scale of a loss is not the same as a gain.

Since the foundation of the AJ Bell product suite, there has been a bias towards short duration assets in the fixed income part of the portfolios. The reason for this wasn’t quantitative and nor was it captured by volatility. It was driven by a hypothesis agreed upon by the Investment Team that there was considerably more chance of a substantial rise in interest rates than there was of an equivalent fall. If this risk to the upside in yields was to occur, the potential for large losses in fixed-income-heavy portfolios was significant. Furthermore, the portfolios were able to be tilted towards short duration whilst maintaining a level of expected return that was similar to market levels of duration. Note, this was not a prediction that interest rates would go up, but merely a recognition that we could offset the risk of its occurrence without really giving up much return.

Investors weren’t necessarily rewarded in a tangible way for this caution – or perhaps ‘risk management’ is a better phrase than ‘caution’ – because for several years, ultra-low interest rates remained just that. In 2022, however, a surprise inflationary pulse drove interest rates globally much higher and suddenly fixed income portfolios holding market levels of duration saw sharp declines. In 2022, the tide went out and we discovered who forgot to put their trunks on.

Risk management is not about predicting the future and tilting portfolios accordingly, it is about recognising asymmetry and taking actions to offset it. Frequently, this caution is not rewarded but that isn’t the right way to think about it – people do not put a seat belt on expecting to crash a car. Equally, investors shouldn’t take actions to mitigate risk with the expectation of something bad happening, but they are glad they did when it does.

Risk is more than just a four-letter word; it is a crucial aspect of portfolio management to ensure best outcomes for clients and avoid foreseeable harm. AJ Bell Investments remains alive to potential risk factors and whilst investors often won’t see this important aspect, they will discover it when the tide goes out.