Experience and observation demonstrates that most individual investors, even those who do a fair amount of research, ultimately make many decisions using so-called ‘gut feel,’ a rough assessment based on what they think will provide good results. In contrast, many professional investment managers depend on sophisticated valuation formulas, also attempting to find good results.
Investment decisions, along with every day ones, are based on reasonable assumptions about future events, ultimately trying to protect oneself from bad results.
Measuring investment risk is always a challenge, as valuations can often vary from what is perceived as fair value. Economic forecasting is plagued with uncertainly, and assumptions about economic cycles are frequently questioned, and this is especially true given recent and current conditions.
Risk management must be based upon the possibility of being wrong in both assumptions and forecasts. The risk is underperforming. Underperformance itself can then become a major risk, as investment managers feel the pressure to take even more chances to “catch up” for having been wrong by taking less risk earlier.
There has been a massive change in capital-market pricing mechanisms. They are now increasingly influenced by structured products, derivatives, and leveraged hedge funds. Both commercial banks and central banks are also major participants, all of which complicates the buy and sell decisions made by ordinary individual investors as well as professionals. When one considers the huge increase in exchange-traded funds (ETF), both active and passive, which invest in various sectors and markets, correlations in many stock groups surprisingly are getting closer together and approaching 1. With such high correlations, an overlay which mainly focuses on “top down” asset mix and sector adjustments makes common sense in this environment.
The selection of securities based upon traditional evaluation and risk assessment should continue to play an important role. For instance, it can help identify when markets are priced excessively. Having two separate functions, one for individual security selection and one for overall asset mix decisions, makes common sense. The forces and considerations affecting both of these decision making criteria are too complicated to try and resolve through only one decision process.
Investment managers and their investment clients must recognize that no matter what ones’ investment decision/direction is and how solid and rational it may appear, there is a reasonable probability of it being wrong. Therein lies the issue. How can you possibly forecast the probability of being wrong?
All the more reason to manage risk using a broad-based approach at the asset mix level.
Therefore, a change in expectations by investors is necessary. This change has as much to do with the faith they put in their managers as it is in the long term outlook for various capital markets. The cornerstone of any investment management strategy must recognize the likelihood of being wrong. This is why risk management is a very important issue, and why we can’t emphasize enough its importance in successfully navigating client assets over the business cycle.