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Point of View

Why managing risk is essential for longer-term returns

By Barry Cowen, Senior Fund Manager

 

Many investors think a portfolio manager’s job is to seek the highest returns possible on behalf of their clients. But managing a portfolio is much more than that.  Indeed, carefully managing the underlying risk we take on behalf of our clients, is almost more important than maximising returns. Let me explain:

Managing the ups and downs

When people talk about the ‘ups and downs of the stock market’, they are in fact referring to volatility. And it’s volatility that keeps us on our toes. Just because we expect an asset to rise in the short term, doesn’t mean it will. Likewise, just because we expect an asset to fall, it doesn’t mean it will. So, how can we balance our expectations and our need for a good return, while protecting ourselves in case we’re wrong?
 
Consider the chart below of two hypothetical assets, performing over time, as shown.

Graph-1-pov-(1).PNG

As you can see, by combining assets that perform differently, at different times, we can produce a positive return (the green line) over the longer term, and we spread the risk over two assets.
 
When choosing a basket of assets, we don’t mind if some of them are expected to fall in the short term. Indeed, we actually want them to, otherwise we would not have the diversity of risk we need. Of course, ideally, all assets in the portfolio would provide positive returns over time, but even if some lose just a little, holding them can be beneficial to the risk level. Think of it as cheap insurance. One hopes to not have to claim on an insurance policy and so we expect/hope for it to be a loss-maker for us, but just in case…

Diversification across assets

The assets in the graph above could be reflective of equities and bonds. They could also be reflective of different styles of equities, for example, those less sensitive to inflation and those more sensitive, or those more exposed to the UK economy and those less exposed.
 
Bonds and equities usually have a degree of negative correlation (as one goes up, the other goes down). The great thing about holding bonds as the ‘insurance’ element is that they can also give us an income whilst owning them. Even if they are expensive, as they are at the moment, they can still be worth holding, albeit in lower amounts. 
 
By holding a broad variety of different types of assets, when events such as Brexit or the US election come along, we worry less. We do expect to have exposure to some assets that will rise and some that will fall. Ideally we will have more of those that rise, but without that crystal ball, positioning perfectly can be difficult.

Choosing the right fund managers

We spend our time understanding exactly the type of stocks (or bonds) that a fund manager buys, then ensure our portfolios are made up of funds that take different approaches. Once we’re happy with the selection of funds we have, we ‘tilt’ the portfolio towards those we think will do best in the short term. If we get it right, then we can, over time, outperform the green line. If however, we get a call wrong, or the unexpected happens, then the outcome is not particularly damaging. We may have assets that will struggle, but we should also have some that thrive.
 
We only select fund managers who are excellent and disciplined at what they do. We want the managers to have the capital available to seize opportunities and buy into great businesses at attractive prices. We can then truly benefit from ‘buy low, sell high’ because we don’t run away from events, and can capitalise on them instead.

In summary

Managing portfolios is not about making as much money as possible, particularly in the short term (the green line on the chart is never at the top). It is about bringing together a variety of assets (including some potentially higher risk ones, with potentially higher returns) in a considered and risk aware way, allowing investors to enjoy a smoother, more comfortable journey, to their goal.
 
If we do a good job, you may even get to that goal a little earlier than anticipated, and more comfortably than expected.

Investing involves risk and the value of investments and the income from them may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.