Risky Business

Ask two investors the same question to define the essence of risk, in the context of saving and investing, and you will almost certainly be given two different answers.

Not quite as different as a finger print or DNA, but there is certainly a very broad spectrum of attitudes and perceptions towards risk, what is it, how to identify it, measure it and protect against it through diversification or other measures.

What has been revealed over the past few years and in other periods of exceptional change is that many previously non-correlated types of investing in fact become correlated to some extent when true panic and fear set in.

The price sensitivity of investors, expected returns and the impact of volatility on investor perception towards the vast array of available investment funds, share classes and other investment vehicles is always going to be a moving target.

Preceding research by burningpants’ affiliate, CoreData Research UK, has identified macro-economic factors, along with shifts in investor risk tolerance levels, are forcing investors to accept a number of realities.

1. Low returns in low risk categories (adjusted for inflation – these returns are typically negative)

2. Forced to take on greater risk to pursue inflation-beating returns

3. Need to consider new types of investment (putting pressure on the benchmark and ratings agencies to consider new splinter investment categories).

Volatility seems to be the new world order, and investors as a group are displaying much greater risk aversion tendencies than in years gone by, however the preceding research mentioned above, reveals that an accurate understanding and full appreciation of risk among investors is extremely polarised.

Some try to measure it, some try to monitor it, some claim risk is the primary consideration in portfolio construction and some outsource worrying about it to their adviser – but it seems that no two investors approach risk in the same way.

In the context of this, a new Funds Management Market Report by CDUK provides a detailed outline of the various drivers behind investor choice and decision making while focussing on three primary topics.

1. Risk
2. Channel (advised, direct, (including endorsing information sources – friends, family, work)
3. Motivating Factors (Why are they doing it? What is their objective? What is their timeline? Is there a figure, if attained, that would facilitate not consuming their principal investment capital)

Meanwhile Fahrenheit, an adviser research tool developed by CoreData in the US reveals advisers are wary of the risk aversion investors are exhibiting, and it is having an impact on how they are anticipating the placement of client assets.

US advisers are providing a delayed reaction to fund performance when it comes to the allocation of client assets and market outlook.

The role played by information in the minds of advisers is one of delayed-cascading.

There is a trickle-down effect resulting in a delay of in the region of 8-10 weeks between reality and decision making when it comes to the perceived level of attraction of 60 different funds.

The chart below demonstrates a reasonable level of correlation between fund performance and adviser inclination to allocate assets when the two points in time are close together i.e. Current quarter performance versus next quarter asset allocation inclination.

However when the point in time between performance and behaviour are separated by more time (i.e. 10 weeks) then this boosts the correlation significantly (see the chart at the bottom of the page) from 0.48 to 0.68 – a very strong correlation for such a multi-variable model.

This suggests advisers require layers of reinforced information before they take action rather than behaving in a reactionary manner.

This is very interesting indeed – it would be good to understand whether this behaviour is merely a reflection of the fact advisers are having to tread carefully in making recommendations given clients are typically more sensitive to risk today, or that advisers themselves are behaving in a more risk averse manner.