Blog

Risk assessment- Why investors are wrong to think they can eliminate risk completely

02/12/2014

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

The world today is a worrying, uncertain and risky place. There is geopolitical risk and macroeconomic inflation to uncertainty while the media is awash with worrying stories about anything from stagnant wage the Ebola virus. People are nervous and investors are cautious, which has set financial markets working overtime to meet an increased demand for products that are seen as ‘lower-risk’.

The underlying mechanisms of some of the resulting ‘solutions’ are too complicated for us here on The Value Perspective to decipher – or at least for us to want to spend time deciphering – but, in simple equity terms, a ‘lower-risk’ portfolio might, for example, be focused on achieving an absolute return or perhaps contain a significant allocation to bonds and so be badged as a balanced fund.

As you can see from the chart below, which was put together by analysts at Evestment, the last few years have seen explosive growth in assets under management within ‘lower-risk’ strategies. And as you may well have gathered from our third set of inverted commas in three paragraphs, we have our concerns as to just how low-risk these strategies really are.

Risk Assessment Graph

Source: eVestment, Citi Research

For while the growth in assets and strategies may have been enormous, there are only a limited number of ways to facilitate them. It therefore follows that when everyone in these strategies starts trying to buy the same sort of assets – or indeed precisely the same assets – at the same time, it forces up the prices.

When people invest in lower-risk strategies, what they are really buying is the perception of lower risk. To put it in simply equity terms once more, that would equate to low volatility, non-cyclical businesses where earnings and profit streams are seen as being more certain and there is perhaps the added comfort of well-known brands – tobacco stocks, food and beverage companies, utilities and so on.

The real issue of course is that it is very difficult – some might even argue impossible – to eliminate risk completely. In articles such as On balance, we have made the comparison of risk being like the air in a long balloon, with the result that when anyone tries to squeeze it away in one area they only succeed in redistributing it – and building up extra pressure – elsewhere.

Thus, if investors are seeking to reduce the volatility of earning streams by buying certain businesses then all they are doing is increasing their risk elsewhere – namely in the elevated valuations they are now having to pay. You think you are buying low risk because you are buying food and beverage stocks on all-time high valuation multiples? Well, good luck to you – but you are only swapping risks.

As the following chart shows, the ‘low-risk’ equity investing of the last five years has pushed companies with less volatile earnings growth to their third highest valuation in the past 27 years. Whereas, traditionally, these businesses have traded on a discount, today they trade at a 15% premium to the market. Nobody wants volatility these days and so it is left on the side-lines, languishing on cheap valuations, which is just the way we like our investments.

Risk Assessment Graph 2

Source: Corporate Reports, Empirical Research Partners

Here on The Value Perspective, we are neither for nor against volatility and we are neither for nor against risk. What we are very much for, however, is valuation and the fact so many people are so worried about all the different risks they see in the world has led to risk itself being lowly valued. Ironically enough, one of the cheapest things you can find in the market these days and therefore with a reduced level of valuation risk … is risk.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

Important Information:

The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated. They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.