- Real Rates – changes in interest rates, the compensation for lending money for a longer period.
- Inflation – changes in prices. Fixed coupon nominal bond investors are particularly vulnerable to the risk of unexpected inflation surprises.
- Growth – unexpected changes in economic growth.
- Credit – associated with bond spreads and default risks.
- Equity – associated with equity-specific risks, the ‘animal spirits’ risk, from company defaults to “periods of exuberant expectations”.
- Emerging markets – associated with taking specific, political risks linked to investing in less developed and therefore less stable markets.
According to the paper, between 75 per cent and 90 per cent of the variability of returns of most liquid asset classes can be explained by using these six factors.
Should a portfolio be so constructed that the underlying holdings have high concentration to one or more of these risks, then it does not matter how ‘diversified’ by asset class or geography it looks at first glance; there will still be deeper-level correlation involved.
In the graph below, it shows a traditional ‘balanced’ portfolio of 40 per cent bonds and 60 per cent equities compared with a portfolio that aims for true diversification.
The first portfolio has a much higher exposure to equity risk and the ‘animal spirits’ that can ride high on sheer exuberance but can turn on a dime.
The second aims to smooth this out, reducing the overall risk.
“Nobody will deny bonds and equities have different risk/reward characteristics”, the paper says, but by analysing the underlying macro factors, for example the blurred line between emerging market equities and emerging market bonds,"a more effective risk-reward trade-off can be made between the two asset classes”, the report states.
Yet there is a case for avoiding too much diversification, with the two main considerations being the additional trading and management costs, and the potential dilution of returns by diversifying so much that the portfolio becomes meaningless as a dynamic multi-asset fund.
Risk management
For Mr Harman, risk management is a "continual process". Indeed, risk has been at the crux of the FCA's various investigations into the way in which portfolios are built and monitored with the end user in mind.
Mr Harman says: "In the finance industry, jargon like 'standard deviation', 'tracking error' and 'volatility' is often used a shorthand to describe and measure portfolio risk.
"But let's be clear: to many of us, 'risk' is the chance of losing money. Pure and simple.
"There is a strong desire to protect our capital."
Using statistical models - stochastic modelling or various different economic measures such as the Sharpe Ratio - to analyse risks can be helpful for those creating and maintaining multi-asset portfolios.
A.D. Wilkie is credited with creating a stochastic model to chart the behaviour of various economic factors back in 1986.
This was building on the work of economists and economic theorists such as Tobin and Markowitz in the 1950s who were looking into the risk and return metrics of investment portfolios, using simulations such as the Monte Carlo method of analysis to evaluate the risks that could affect the outcome of different investment decisions.
