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Know Thy Risks! Three risk areas to remember and that people often overlook.

The big picture
Most people consider risk when they invest but rely on recent experience to guide them. This is often a mistake. There are three areas where this problem is common; making big bets, ignoring long term history and failing to consider hidden risks within the portfolio.


The detail
Investors often make critical mistakes by relying on recent experiences when assessing risks. The most common mistakes are:

1. Overreliance on big bets:
People are often tempted to make large bets in their portfolios based on recent events. This approach misunderstands the nature of risk by assuming certainty in future outcomes. Good analysis can reveal that something may be likely, but nothing is certain.

A relatively recent example of this would be anyone expecting inflation for most of the last 30 years. The entry of China into the world trade system and Quantitative Easing led many people to predict there would be worldwide inflation, but this didn’t happen.

2. Neglecting long standing risks:
Investors tend to forget about enduring risks that may seem old-fashioned or have not been demonstrated recently. Risks like inflation, currency fluctuations, or economic crises in specific regions are always present, and overlooking them can lead to complacency. When problems like this happen, it’s often a shock. A robust portfolio will always consider these persistent risks.

3. Ignoring hidden risks:
There are factors behind investments that have a large influence on how they perform, but aren’t easy to see. These can mean that investments, even those that are not similar, can rise or fall together which reduces diversification and increases the risk within your portfolio.

Examples of these hidden risks are interest rate fluctuations, currency exposure, or regional economic crises. Recent history is often a poor guide to this type of risk because there may not have been a change to the factor in question.

Interest rate risk is a good example. Many investments, including bonds, property, infrastructure, and utilities, are sensitive to changes in interest rates. So even though they are classed as different asset types (asset classes), an increase in rates can mean that all of these investments fall at the same time.

When constructing portfolios, it is crucial that we:

1. Diversify across investments: Avoid putting all resources into one high-conviction position, recognising that predicting future events is inherently uncertain.

2. Account for enduring risks: Incorporate protections against persistent risks, such as inflation, currency movements, and potential economic crises, even if they have not occurred recently.

3. Be mindful of hidden risks: Understand the sensitivity of investments to factors like interest rate changes to prevent building a brittle and low-quality portfolio.

4. Maintain a broad range of positions: To safeguard against unknown events and changes in the global economy, it’s best to diversify investments across countries and asset classes.


In conclusion

I’m sure you can understand why we build portfolios the way we do; to avoid taking big bets. This is why we have lots of different positions in lots of difference countries, in lots of different asset classes.

Trying to manage the known risks, like inflation, economic crises and currency changes is an inherent part of our investment culture. We regularly check our portfolios to make sure we're doing all we can to mitigate the risk of one of these events occurring.

As an investment committee, we discuss hidden risks regularly, looking at our portfolio of investments to try and make sure we’re not taking the same position unknowingly and exposing our clients to unnecessary risks.

This culture of how we invest is why we’ve had both strong and much more stable returns than our competitors.

Presented by Guy Myles. Capital at Risk.