understanding risk and its effective management romeo makhubela ceo
TRANSCRIPT
Understanding risk and its effective management
Romeo Makhubela
CEO
• Introduction – what is risk?
• 3 big picture concepts
– Time
– Fund dynamics
– Regime switching.
• Conclusion
• Introduction – what is risk?
• 3 big picture concepts
– Time
– Fund dynamics
– Regime switching.
• Conclusion
Agenda
Institute of Risk Management considers
• Uncertainty (travel arrangements)
• Danger (skydiving)
• Probability (SA to win Rugby World Cup 2011)
• Variability (buying a lotto ticket)
• Dread (shark attack).
Peter Bernstein in his book “Against the Gods: the Remarkable Story of Risk” demonstrates a perspective that requires one to
• “define what may happen in the future and choose among alternatives”.
• he states that risk should not be feared, and goes hand in hand with challenge and opportunity.
Institute of Risk Management considers
• Uncertainty (travel arrangements)
• Danger (skydiving)
• Probability (SA to win Rugby World Cup 2011)
• Variability (buying a lotto ticket)
• Dread (shark attack).
Peter Bernstein in his book “Against the Gods: the Remarkable Story of Risk” demonstrates a perspective that requires one to
• “define what may happen in the future and choose among alternatives”.
• he states that risk should not be feared, and goes hand in hand with challenge and opportunity.
Its all about perspective
What is risk?
The quantifiable likelihood of loss or less-than-expected returns due to
Currency- Interest Rate-
Inflation- Equity-
Principal- Credit-
Country- Unsystematic-
Economic- Call-
Mortgage- Business-
Liquidity- Counterparty-
Prepayment- Purchasing power-
Opportunity- Event-
Income-
……….RISK
The quantifiable likelihood of loss or less-than-expected returns due to
Currency- Interest Rate-
Inflation- Equity-
Principal- Credit-
Country- Unsystematic-
Economic- Call-
Mortgage- Business-
Liquidity- Counterparty-
Prepayment- Purchasing power-
Opportunity- Event-
Income-
……….RISK
Investor Words definition
What is investment risk?
What factors are in play that can derail the expected outcome?
• Risk is the future uncertainty of a current decision.
• To be make money, we need to be exposed to it.
• How much we can tolerate depends on
– how financially wealthy we are,
– what we are trying to achieve, and
– how much time we have to wait.
• It is the amount of exposure to risk, of the right kind, that determines success or
not; but:
• Risk is NOT independent of expected return.
• Risk is the future uncertainty of a current decision.
• To be make money, we need to be exposed to it.
• How much we can tolerate depends on
– how financially wealthy we are,
– what we are trying to achieve, and
– how much time we have to wait.
• It is the amount of exposure to risk, of the right kind, that determines success or
not; but:
• Risk is NOT independent of expected return.
Some commentary
• Time
– As a general rule of thumb, the longer the time to one’s target date, the
more aggressively one can invest.
• Fund dynamics
– one “solution” does not fit all; requires migration through complementary
solutions
– risk management solutions can no longer be static.
• Prevailing environment (Regime switching)
– within this dynamic solution, one must respond to differing market
environments.
• Time
– As a general rule of thumb, the longer the time to one’s target date, the
more aggressively one can invest.
• Fund dynamics
– one “solution” does not fit all; requires migration through complementary
solutions
– risk management solutions can no longer be static.
• Prevailing environment (Regime switching)
– within this dynamic solution, one must respond to differing market
environments.
3 big picture concepts that impact ability to assume risk
Risk acceptance
00 01 02 03 04 05 06 07 08 09
1900 15% 18% 4% -7% 22% -20% 15% -11% 41% 30%
1910 -14% -15% 7% -6% -12% 7% 12% -3% 6% 33%
1920 -43% 2% 76% 10% 17% 16% 25% 8% 2% -2%
1930 -7% -6% 34% 113% 33% 17% 28% -20% 1% -7%
1940 0% 16% -3% 19% 8% 22% -4% -13% -9% 25%
1950 -10% -1% -8% 0% 18% -7% -6% -4% 19% 32%
1960 -2% 10% 27% 22% 15% 4% 16% 18% 48% -14%
1970 -30% 2% 52% -4% 1% -22% -12% 18% 23% 70%
1980 21% -12% 22% 3% -3% 20% 33% -17% 2% 35%
1990 -17% 13% -11% 41% 12% 2% 0% -10% -16% 51%
2000 -7% 21% -17% 11% 20% 41% 34% 10% -32% 22%
2010 14%
over the short term
Time: Equity returns are uncertain...
data
: an
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201
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data source: Prof C Firer annual data 1900 – 2008
00 01 02 03 04 05 06 07 08 09
1900 9%
1910 6% 3% 3% 3% 0% 3% 2% 3% 0% 1%
1920 -3% -2% 3% 5% 8% 9% 10% 11% 11% 8%
1930 13% 12% 9% 17% 18% 18% 18% 15% 15% 14%
1940 15% 17% 14% 7% 5% 5% 2% 3% 2% 5%
1950 4% 2% 2% 0% 1% -2% -2% -1% 2% 3%
1960 3% 4% 8% 10% 10% 11% 13% 16% 18% 13%
1970 9% 9% 11% 8% 7% 4% 1% 1% -1% 6%
1980 12% 10% 8% 9% 8% 13% 18% 14% 11% 9%
1990 5% 7% 4% 8% 9% 7% 4% 5% 3% 4%
2000 6% 6% 5% 3% 4% 7% 10% 12% 11% 8%
2010 11%
Equity returns...
data
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data source: Prof C Firer annual data 1900 – 2008
exceed inflation over almost all periods of 10 years or longer
00 01 02 03 04 05 06 07 08 09
1900 16% -6% 0% 10% 11% 9% 12% 4% 8% -1%
1910 -11% 1% 0% 1% 3% -15% -7% -5% 2% -7%
1920 -20% 25% 28% 6% 4% 6% 7% 5% 6% 5%
1930 6% 9% 3% 35% 8% 9% 3% -4% -1% 0%
1940 2% 4% -3% -1% -1% 2% 6% -3% -9% -3%
1950 -5% -9% -10% 4% 4% -3% 1% 1% -4% 5%
1960 2% -2% 20% 3% -2% -10% -4% 5% 4% 3%
1970 -11% -6% 5% 0% -17% -6% -8% 3% 9% -1%
1980 -19% -10% 16% -13% -10% -6% 15% 0% -4% 6%
1990 1% -2% 17% 21% -17% 22% -3% 22% -4% 27%
2000 12% 14% 4% 18% 10% 8% 0% -4% 7% -7%
2010 11%
data source: Prof C Firer annual data 1900 – 2008
Bond market returns
data
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data source: Prof C Firer annual data 1900 – 2008
are driven by inflation
00 01 02 03 04 05 06 07 08 09
1900 6%
1910 3% 4% 4% 3% 2% 0% -2% -3% -3% -4%
1920 -5% -3% 0% 0% 0% 2% 4% 5% 5% 6%
1930 9% 8% 6% 8% 9% 9% 9% 8% 7% 6%
1940 6% 5% 5% 2% 1% 0% 0% 0% 0% -1%
1950 -1% -3% -3% -3% -3% -3% -3% -3% -2% -2%
1960 -1% -1% 2% 2% 2% 1% 0% 1% 2% 2%
1970 0% 0% -1% -2% -3% -3% -3% -4% -3% -3%
1980 -4% -5% -4% -5% -5% -5% -2% -3% -4% -3%
1990 -1% 0% 0% 3% 2% 5% 3% 5% 6% 7%
2000 8% 9% 8% 8% 11% 9% 10% 7% 8% 5%
2010 5%
Bond market returns
data
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data source: Prof C Firer annual data 1900 – 2008
stay negative in real terms for long periods as inflation rises
00 01 02 03 04 05 06 07 08 09
1900 0% -5% 1% 13% 9% 10% 11% 5% 4% -3%
1910 -11% -1% 1% 2% 2% -1% 0% -4% -3% -6%
1920 -14% 16% 23% 6% 2% 3% 5% 2% 3% 3%
1930 6% 6% 9% 4% -1% 1% 0% -2% -3% -1%
1940 -4% -6% -8% -5% -4% -1% -2% -4% -6% -3%
1950 -6% -7% -5% 1% -2% 0% 1% 0% 0% 0%
1960 2% 3% 2% 1% -1% 2% 1% 4% 3% 2%
1970 2% 1% 0% -4% -3% -2% 1% -1% -2% -7%
1980 -9% -1% 4% 4% 7% 3% -5% -4% 1% 3%
1990 5% 2% 6% 3% 1% 7% 6% 11% 10% 8%
2000 3% 4% 1% 8% 4% 3% 3% 1% 1% 3%
2010 3%
Cash returns
data
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data source: Prof C Firer annual data 1900 – 2008
are not the perfect hedge against inflation (even before tax)
00 01 02 03 04 05 06 07 08 09
1900 4%
1910 3% 4% 4% 3% 2% 1% 0% -1% -2% -2%
1920 -3% -1% 1% 1% 1% 2% 2% 3% 4% 5%
1930 7% 6% 5% 4% 4% 4% 3% 3% 2% 2%
1940 1% -1% -2% -3% -3% -3% -4% -4% -4% -4%
1950 -4% -5% -4% -4% -4% -3% -3% -3% -2% -2%
1960 -1% 0% 1% 1% 1% 1% 1% 1% 2% 2%
1970 2% 2% 1% 1% 1% 0% 0% 0% -1% -2%
1980 -3% -3% -2% -2% -1% 0% -1% -1% -1% 0%
1990 2% 2% 2% 2% 1% 2% 3% 5% 6% 6%
2000 6% 6% 5% 6% 6% 6% 5% 4% 4% 3%
2010 3%
Cash returns
data
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data source: Prof C Firer annual data 1900 – 2008
over the short or long term
ris
k
investment horizon - years
equities
bonds
cash
absolute low risk moderate risk equity oriented growth
Asset class risk vs time
Equities deliver higher returns but with exponentially higher risk over the short term
• Risk management solutions can no longer be static.
• Consider a closed pension fund with members with characteristics differing by– age– retirement date– gender– contribution value– tax rate– accumulated benefits.
• The solution for the retirement fund as a whole is driven by the aggregate cash flows, which include contributions (by active members) and withdrawals by retired members.
• This solution is not simply 100% allocation to one fund, to and from which contributions and withdrawals are made.
• Risk management solutions can no longer be static.
• Consider a closed pension fund with members with characteristics differing by– age– retirement date– gender– contribution value– tax rate– accumulated benefits.
• The solution for the retirement fund as a whole is driven by the aggregate cash flows, which include contributions (by active members) and withdrawals by retired members.
• This solution is not simply 100% allocation to one fund, to and from which contributions and withdrawals are made.
Fund dynamics
Dynamic solution superior
Economic cycles, a starting point
Regime switchingn
orm
al
need to be viewed in three distinct states
Economic cycles
to the long term SAA to reflect the dynamics of each macro environment
Temporal adjustment
Equity Bond Cash
Con 13 27 60
Mod26 19 55
Agg 35 15 50
Equity Bond Cash
Con 29 29 42
Mod50 25 25
Agg 65 15 20
Equity Bond Cash
Con 40 32 28
Mod64 27 9
Agg 75 20 5
value add
Combining time, dynamics & environment
Statistic Balanced (Static)
Balanced (Risk mitigating)
Balanced (Opportunity
seeking)
Balanced (Regime
switching)
Annual Return 16.2% 13.3% 17.0% 17.9%
Annual stdDev 10.8% 6.2% 13.2% 10.5%
Sharpe ratio 0.7 0.7 0.6 0.8
Maximum Drawdown -19.3% -8.1% -25.7% -13.4%
• Risk is the future uncertain outcome of a current decision.
• Especially in the new millennium, three important facets to recall and consider are time, fund dynamics and regime switching.
• Time in the markets is a management tool.
• Static solutions: no more.
• Regime switching, as a critical component of the dynamic solution.
• Risk is the future uncertain outcome of a current decision.
• Especially in the new millennium, three important facets to recall and consider are time, fund dynamics and regime switching.
• Time in the markets is a management tool.
• Static solutions: no more.
• Regime switching, as a critical component of the dynamic solution.
Conclusion
Questions?
Regulatory information
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