Risk Is Not a Number

Economic, political and financial activities — particularly those occurring around the world — often turn investors’ focus to risk management. Investors then turn to their financial advisor for education and guidance about risk diversification.

At Aberdeen Asset Management, we don’t believe in simply monitoring a few well-known risks, nor do we believe that risk can be reduced to one equation, such as a beta measure or a Sharpe ratio, for example.  We view risk in multiple difference scenarios and with the possibility of many different outcomes, all of which must be explored in depth.

Let’s look at several ways we examine risk:

• Market Risk is frequently the most widely known investment risk.  This refers to volatility or equity risk and is measured by swings in the stock market.

Since the end of the financial crisis in 2008, the S&P 500 Index has fallen 5% in a week on nine separate occasions.  Though the stock market has had an upward trajectory over that time period, stock markets have still exhibited substantial volatility, often dropping significantly in only a matter of days.

But remember, volatility results in a loss only when you sell at a loss.  Over the last 15 years, the S&P 500, for example, has reached various peaks and troughs each year, but is nearly impossible to predict the short-term movements of the market.

• Credit Risk is also known as default risk.  This type of risk is normally attributed to fixed income investments and attempts to predict counterparty uncertainty in the event that a borrower fails to meet financial obligation(s).

It’s impossible to say if and when a fixed income investment will default on its loan, but ratings agencies such as Moody’s, Fitch, and Standard and Poor’s (S&P) may give you an idea of what to expect.  The agencies rate corporate and sovereign debt on a scale of “investment grade” to “speculative grade” with a range of delineations in between.  These delineations are designed to provide an overall picture on the likelihood of default.

• Foreign exchange risk is caused by fluctuations in foreign currency valuations, which can not only impact portfolio investments in currency, but also invested equities and geographies.

At Aberdeen we are strong believers in the potential long-term return and diversification benefits of international investing.  However, depending on your home country, foreign currency exchange rates can have a significant effect on portfolio returns, either positively or negatively. 

• Country risk refers to investing in a particular country, whether economic or political. Country risk can vary dramatically depending on the individual attributes of that territory.

In our opinion, markets may change on a daily, weekly or monthly basis; however, we believe that over the long term, stock markets will reflect company fundamentals.  This is why good due diligence, bottom-up fundamental research, and never ending evaluation and monitoring are cornerstones of Aberdeen’s investment process.

• Interest rate risk measures the impact of interest rate changes on the value of an investment.

In today’s environment, the actions of central banks around the world are having substantial effects on markets and economies.  Understanding how specific asset classes may be affected by monetary policy is an important step in assessing and managing interest rate risk.

Ways to Reduce Potential Risk

A key to any successful investment strategy is the skilled use of diversification. The goal is a well-diversified portfolio of holdings that perform differently throughout various factor (or factors) facing a particular investment strategy.