Some thoughts on managing risk

In my last post, I talked about the importance of risk management. In order to manage risk we must understand what the risks are and our tolerance for the risks. The biggest risk with “risk assets” such as stocks is the risk of capital loss as your capital is not guaranteed. It can go up or down, and after the 50% drop in the share market in 2008-09, investors are now well aware of that risk and many are opting for fixed income investments because they are seen to be “safer”. Issuers of fixed income products have taken advantage of the increased demand and the market has been flooded with retail fixed income products such as hybrids. While I am a big believer that super funds should have a bigger allocation to fixed income, there are also risks with fixed income which we must understand and manage. The obvious risk with fixed income is “credit risk” as fixed income products are essentially unsecured debts. We lend our money to the issuers in return for an interest so the credit quality of the issuer is very important. How can we measure the credit quality of issuers? In the past we would normally use credit ratings issued by rating agencies but these have been proven to be unreliable time and time again. Based on credit ratings, BHP is supposed to be more risky than our Big 4 banks, yet BHP can borrow at a lower interest rate than our Big 4 banks, so it looks like credit ratings are getting pretty meaningless.

Where the debt sits in the debt hierarchy (see chart below) is also quite important in determining risk as “senior” debt holders will get paid before “junior” debt holders. Most hybrids are junior or subordinated debt so they are riskier than term deposits or covered bonds. Term deposits with banks are also guaranteed by the government which eliminates the credit risk of the issuer. Hybrids have been very popular and recent issues have been oversubscribed. Although they pay a slightly higher yield compared to term deposits, I wonder if investors understand the risk that they carry and if they are adequately compensated for the added risk.

The biggest risk with fixed income is actually inflation risk. All central banks want inflation and actually target to create inflation of 2-3% every year. While there is definitely less risk of capital loss with fixed income, there is also less potential for capital gain so they may not be able to keep up with inflation. Risk assets like stocks and property are more likely to keep up with inflation which is why I believe we should have some allocation to risk assets in our investment portfolio. The amount we allocate depends on our tolerance for volatility. Ideally we would love to be able to stay in the safety of fixed income until the next bull market comes along but unfortunately no one will ring a bell when the bottom is reached so we can all safely jump back into the stock market. The Australian share market has already had a major correction in 2008 and many stocks are still trading at well below their all-time highs in 2007. A universal measure of stock value is ratio of Price to Earnings. With the ASX/S&P200 at the current level of around 4300, the P/E is 13x which is historically cheap. When the index was at 6700, the P/E was 18x so the risk of investing in shares now is actually lower than in 2007.

As there is risk in all investments, one way to manage risk is diversification i.e. make sure you have both defensive assets such as cash and fixed income as well as risk assets such as shares and property. Another way to manage risk is to always buy at a discount to current market price. When we buy a new investment, we really do not know if it will go up or down in value after we buy it. If we can buy it at 5-10% cheaper than fair market value, then we have a margin of safety. It is possible to buy almost any investment at a discount. With property, you can always make an offer at below the asking price. Our property investment mentor always manages to get bargains. He would look at 100 similar properties to get a good feel of the market price. When he spots a good bargain because the sellers have not done their homework as well as he has, he quickly makes his offer to buy. We can do the same with stocks. We can put stocks that we like on our watch list and when they reach a good price by our own valuation, we make an offer to buy at the price we would like to pay by selling put options at that price. For example, if BHP is trading at $35 and you think that is a good price, you can sell a put option at a strike price of $34. This is my favourite stock acquisition strategy as it gives me a safety buffer when I buy stocks. We can even buy fixed income products at a discount. If you are interested in hybrids, instead of rushing to buy at the initial offer price, look at the secondary market. There are some that are trading at below their par value so you could be buying them at a discount.

My own views on risk are constantly being challenged. In the last few weeks, I have been challenged by two people – the first person thought I took too much risk and the second person thought I did not take enough risk. We all have different tolerance for risk. What is important is that we understand and are comfortable with the risks in the investments we make.

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Posted by on Mar 4th, 2012 and filed under Risk Management. You can follow any responses to this entry through the RSS 2.0. Both comments and pings are currently closed.
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