The biggest lesson to be learned from the global financial crisis is the greater awareness of the impact of risk on any investment. Whether the appreciation for risk will remain well beyond the end of the crisis -- whenever that may be -- remains to be seen.
Shane Oliver, Sydney-based head of investment strategy and chief economist at AMP Capital Investors, highlights two key points from the global financial crisis. First, quantitative measures of the riskiness of assets and the correlations between them are highly unstable. Second, there is a role for alternative and more exotic investments in portfolios, but their diversification benefits should not be exaggerated.
Oliver notes that risk is a rather esoteric concept that has different meanings: It may be seen as the risk of a capital loss, or the volatility of an investment, or the risk that a portfolio won't generate enough returns for an investor to live on in retirement. There is no simple definition, he says, but most tend to focus on the volatility of an asset as the best guide to risk.
Traditionally a key approach to managing the risk of an investor's portfolio was to combine a mix of defensive assets where the bulk of the return comes from income -- namely cash and government bonds -- and growth assets where there is significant potential for higher returns from rising capital values but also more volatility -- mainly equities and property. This approach saw investment funds categorised according to their mix of defensive and growth assets.
However, Oliver notes that for a variety of reasons this approach was being called into question and has given way to a more sophisticated approach that is less constrained by the growth or defensive pigeonholing of assets but rather risk control in the form of a more diversified mix of assets.
Oliver cites the reasons that have led investors to consider a more sophisticated risk approach: A search for higher investment yields as cash and bond yields fell compared to 1970s and 1980s levels; the realisation that the growth/defensive categorisation for various asset classes was blurred (for instance, property investments have some bond-like characteristics, while fixed interest was increasingly including private sector debt which was more related to equities); the bursting of the IT bubble in 2000 encouraged investors to follow the lead of endowment funds such as those at Harvard and Yale to invest in a wider range of risky assets than just equities and property; and computing power and the growth of sophisticated quantitative techniques for measuring risk allowed and encouraged more sophisticated risk controls than just the pigeonholing of assets into defensive and growth.
Embracing a more sophisticated risk approach has led to the following developments with regard to portfolio construction, according to Oliver: The use of real estate investment trusts (Reits) as a partial replacement for government bonds on the grounds they will provide a higher yield based return than bonds but with just a bit more risk; the use of funds of hedge funds as a replacement for government bonds on the grounds they will provide a cash or bond plus return with low correlation to equities; private sector debt in fixed interest portfolios; and Increased exposure to more exotic investments such as various credit based investments with acronyms such as CDOs, CLOs, emerging market equities and debt, private equity, commodities and infrastructure on the grounds they would provide more diversification.
Oliver highlights several important lessons when it comes to managing the risk of an investment portfolio. First, quantitative measures of risk and correlation are inherently unstable. Second, risk and correlations between assets are not a given but rather are influenced by the actions of investors themselves. Third, flowing from all this it is clear that there is a lot of value in the rather simplistic yet old fashioned approach to risk control -- government bonds and cash provided good diversification last year. Assets such as Reits, hedge funds and credit are much higher risk. Fourth, risk cannot be divorced from valuation risk -- the more an asset's price goes up, the higher the risk of an eventual fall. Finally, flowing from all of this is that diversification doesn't necessarily justify a higher exposure to risky assets.