INVESTING IS OUR STRONG SUIT

A daily column on investing by Orbis Investment Management Limited

You may meet a senior representative from Orbis Investment Management Limited at the hotel. To make an appointment please contact the hospitality desk or call the Churchill Suite, room phone: 7554.

Measuring Risk

Risk is not a consideration unique to investing - it is a concept that should be familiar to all of us. But, while familiar, the potential risk of an investment is often overlooked or not considered. The historic returns of a security, particularly for the most recent periods, are often the primary influence on an investor's decision-making.

Defined simply, risk represents the potential for unfavorable outcomes that result from decisions made in an uncertain world. When an investor makes an investment he or she gives up cash now in the expectation of receiving a larger amount of cash in the future. In this context, risk is normally associated with the probability that the investor does not receive the expected amount of cash back in the future. Most investors aim to maximize the returns on their investments while limiting the risk that their investments will lead to monetary loss.

The most common way to measure the potential for monetary loss is to evaluate how much the value of a portfolio fluctuates over time. A portfolio that appreciates smoothly has a much lower probability of loss than one that oscillates wildly. Numerically, the fluctuation in the value of a portfolio can be measured by volatility. Investors will only tolerate a high level of volatility if they expect a high return from the portfolio. For example, cash deposits tend to appreciate much more smoothly than equity investments. Thus investors expect, and have received historically, higher returns from equities than from cash deposits.

Although volatility is the dominant measure for risk, there are many other aspects of risk that can be measured.

Market Risk measures the sensitivity of the portfolio to movements in stock, bond, currency or commodity markets. It is important for a portfolio to measure its exposure to each of these markets so that the risks associated with these exposures can be compared with the corresponding expected returns. A portfolio should not take on market risk unless the return expected from the exposure is appropriate.

Another type of risk, Credit Risk, refers to the risk that counterparties fail to return invested funds when they are due. For example, if an investor owns a bond in a company that becomes bankrupt, the investor is unlikely to receive full payment on the bond.

Liquidity Risk is the risk that you will not be able to convert your investment to cash promptly.

Relative versus Absolute Risk
Perhaps surprisingly not all investors associate risk with monetary loss. Certain groups of investors, for example large institutions, frequently make a decision to allocate a certain proportion of their capital to a specific asset class, such as equities, and employ an active manager to take care of the portfolio. These institutions expect the active manager to generate returns that are higher than the returns that could have been achieved simply by investing in a passive equity index. This is natural - the manager's fee is higher than the fee for investing in a passive fund and hence the manager is expected to generate returns that are higher than those of the passive fund. The risk an institution takes by employing an active manager is that the manager fails to generate returns in excess of those of a passive fund i.e. some institutions define risk as the likelihood of under performing a passive index.