Economics & Markets

The perception of risk

By Michael Gray
Head of Investments NZ New Zealand

Cutting through the investment noise and why being positive sounds naïve
As we enter another period of lockdown, the current environment seems to be one of extreme uncertainty. Despite this, the basic principles of investing remain timeless, and importantly how we focus on and manage risk.

A definition of risk is that “more things can happen than will happen”. This quote is attributed to Elroy Dimson who said: 

You manage risks by comparing them to potential returns, and through diversification. Remember, just because more things can happen than will happen doesn’t mean bad things will happen.

Identifying risks is relatively easy – we  tend to focus on what can go wrong. However, for professional investors the appropriate judgement of risk is critically important. Investors must have the ability to identify the right risks to focus on, assess the probability of a risk eventuating and evaluate the likely impact on an investment portfolio. Or alternatively, and more simply, investors need to stay focused and cut through the noise.

Shane Oliver, a colleague and Head of Investment Strategy & Chief Economist at AMP Capital Australia, recently published a note “five ways to turn down the noise and stay focused as an investor”.

In brief, the key points to note are:

  1. Put the latest worry in context. There has always been an endless stream of worries, including world wars, earthquakes, the Great Depression, geopolitical crises, terrorist attacks and pandemics, to name a few.  Yet despite all the events over the last 100 years or so global equity market returns have actually been good “as shares climb a long-term wall of worry”.
  2. Recognise how markets work. A diverse portfolio of shares returns more than bonds and cash longer term because it can lose money in the short term. Shares are more volatile, which is driven by worries. Bad news, bouts of recovery and investor euphoria are normal. This is the price investors pay for higher longer-term returns.
  3. Find a way to filter news so that it doesn't distort your investment decisions. In my mind, to help filter the noise, successful investors have documented investment processes and the discipline to follow them. For those saving for retirement, a preferred approach would be to adopt a long-term strategy and stick to it. 
  4. Don’t check your investments too much. 
  5. Look for opportunities that bad news and investor worries throw up. 

To conclude, there is no denying that things occasionally go wrong, weighing on investment returns. But long-term experience shows that most of the time predictions of financial gloom are wrong and end up just distracting investors from their goals.

The psychology of sounding positive

As noted above, identifying risks is relatively easy – with a tendency to focus on what can go wrong. At the same time, it is well documented that those expressing a negative view can sound smart and sophisticated relative to a positive view that can come across as naïve.

John Steward Mill wrote 150 years ago: “I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.” More recently, Warren Buffett is quoted as saying “bearish arguments always sound sophisticated”. (In financial market terms, being ‘bearish’ is having a negative outlook.)

The bullish view – or having a positive outlook – sounds like it is not taking into consideration current risks and is often based on a qualitative assessment rather than hard data. Thus, sounding naïve.

Conversely, the pessimistic view sounds well thought out and is usually backed by loads of data (which is often backward looking). The negative view often addresses a possible imminent threat, appeals to our fear of incurring a loss, and often requires us to take some action. Thus, being pessimistic can sound smarter.

Meanwhile, the positive view is often more calmly presented, concluding things are okay, and no action is required at this time.

This is well worth remembering when you are trying to turn down the noise.

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Important notes

This blog post has been prepared to provide general information and does not constitute financial advice in accordance with the Financial Markets Conduct Act 2013. An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.

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