Risk Assessment

Conventional Risk Assessment

Standard industry practice among financial advisers assumes that risk <> return is a spectrum along which investors can select the setting that suits them best. As suitability is a formal requirement of the FSA for advisers dealing with private clients in the UK, heavy reliance is placed on a precisely definable measure that can protect advisers against claims of negligence, made with the benefit of hindsight about future investment performance. Normally risk and reward are respectively defined as the volatility and average rates of monthly returns over the past 5-10 years. This diagram illustrates the practice. While seductively scientific, it often leads investors into unsuspected dangers and missed opportunities as indicated by the arrows.

Radical Risk Assessment

Investors RouteMap assesses two alternative dimensions of risk.

• Poor Trends - These may be based on price action or economic developments. The RouteMaps use chart technical analysis, seasonal trading patterns, key economic indicators and revisions to forecasts. 
• Poor Value - Value is subject to many differing interpretations, of which we have chosen those that can be quantified and compared across a wide range of countries and markets. These may be based on cyclically-adjusted real p/e ratios, real yields, real effective exchange rates or other ratios that are appropriate for different asset classes.

Overvalued assets may continue to show good momentum, and conversely assets that represent good value may display poor momentum. Risk is therefore minimised, when trends are favourable and valuation is cheap. That is when future returns are also best. Therefore risk is mininised by maximising returns. 

As a result of structural factors, such as the systematic under-recording of profits in some countries, it may often be less sensible to look at valuation of shares compared to peers and more meaningful to consider valuation relative to their own past, as Investors RouteMap does.

Volatility

There are two great myths about volatility

• Volatility is often misrepresented as risk, because it is the one kind of risk that is easily quantifiable. However no-one every complains about upside volatility.
• Volatility is not constant, but varies with the investment cycle. At the start returns are positive, while volatility is low. Then volatility rises as prices rise further, but volatility keeps on rising as prices crash, and only peaks when prices have established a low.

Therefore it is important to assess the volatility of investments over a long time scale that includes a variety of conditions.