Is risk a reason to avoid investing?

Is risk a reason to avoid investing?

Investors often express the desire to avoid ‘risk’ – most often when market conditions become volatile and the outlook is uncertain. However, risk is an integral part of the reason why some investments tend to pay higher returns over time. Thus, the idea of avoiding risk is inherently problematic and even a little contrary to the idea of investing itself!

Therefore, we frame this question somewhat differently in terms of our 3M philosophy. We would argue the more appropriate question to ask is: Can we quantify the potential risk of an investment, and are our clients sufficiently rewarded for taking on this risk? This unique perspective is integral to how we construct portfolios and where we find opportunities, especially during a time in the market that many would label as ‘riskier’ than usual.

Putting your finger on risk
While you’d expect that all investors assess risks similarly, this is not the case. We often find that emotion can have a substantial impact on how investors evaluate risk, becoming either overly negative or positive in their assumptions. Recent examples include:

• The steep valuations some technology stocks enjoyed until recently implied that their earnings would continue along similar trajectories to those of the past, even as the tailwinds that drove pandemic-level adoption died down and interest rates started to ramp up.
• The shares of many local companies are priced at excessively pessimistic levels, often forgetting that local businesses have been facing very depressed economic conditions and poor service delivery for over a decade, and have delivered to investors despite this.

What the above shows is that risk cannot easily be divorced from valuation, and since the latter is highly susceptible to emotional biases, so are the conventional wisdom and narratives about what is risky and what is not. We often find that a sufficiently low valuation de-risks a potential investment and opens up an extremely attractive positively skewed range of outcomes. If the risks are already reflected in the price, the investment is often substantially less risky than the prevailing narrative would suggest.

Is the reward big enough?
A cornerstone of our 3M investment philosophy is buying assets at a sufficient margin of safety, so that they are more likely to increase in value over time. While all investments carry some measure of risk, some reward investors more handsomely than others for taking on this risk. Because we run a globally integrated, benchmark-agnostic process, we don’t consider investments in isolation. Rather, they have to compete for inclusion in our portfolios against the best alternative use of our funds.

For example, in our multi-asset portfolios, the starting point is the return on local cash, and we then require an appropriate risk premium over and above this before we will include an asset in our portfolios. This means local and global assets compete for inclusion on a similar playing field, rather than being included because they are part of an index or a benchmark. In our view, this raises the bar for investments, leading us to always ask whether the reward is sufficient to compensate our clients. Japanese financials provide a good example of our thinking. As pressure on Japanese interest rates increased, the risks in this space became amplified, and we therefore felt our clients’ funds could be allocated better elsewhere. We have aggressively sold out of most Japanese financials, including long-time portfolio holdings Japan Post and Resona, since the beginning of the year.

Portfolio construction helps to manage risk
When considering assets individually, as we have done above, you could be duped momentarily into thinking that is all there is to it. However, the funds we manage consist of many different shares, and in constructing them we not only seek to avoid unwanted correlations and concentrations of risk, but also to actively exploit the power of diversification to our clients’ advantage. This not only reduces risk at the portfolio level, but also ensures our portfolios benefit from a variety of different drivers of returns. This helps to ensure that our portfolios can deliver robust and sustained performance to clients.

While it may be tempting to think of risk as something to be avoided, it is in our opinion better viewed as something to be carefully assessed and actively managed. No investment – not even cash – is completely risk free because, in the long run, inflation can pose a risk to complacent investors. That is why we believe investors are best served by partnering with a proven investment manager who applies a rigorous process when evaluating investment opportunities, and constructs portfolios following an integrated process, as this provides investors with the best chance of growing their wealth in the long term.

John Gilchrist is the co-Chief Investment Officer of PSG Asset Management.