The dirty dozen

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This post is a guest contribution by Niels Jensen, chief executive partner of London-based Absolute Return Partners.

“Risk concerns the deviation of one or more results of one or more future events from their expected value. Technically, the value of those results may be positive or negative.” Wikipedia

The definition of risk

No, I am not going bonkers. Some egghead came up with this formula as a way to define risk, but we can do better than that. In the world of finance, risk is essentially the probability of an investment’s actual return being different from the expected return. As most of us are not overly concerned about actual returns being higher than expected, it is fair to say that in practical terms, risk is a measure of the probability of losing some or all of your investment.

Now, risk cannot always be quantified, and there is indeed a term for immeasurable risk. It is called uncertainty. Good investment management is founded on robust risk management or, as we ought to label it, the ability to manage uncertainty well. Many moons ago, a good friend with more grey hair than myself gave me the advice to focus on the management of uncertainty. His philosophy was that if you manage that well, over time, performance will take care of itself.

Now, I must confess that over time I have made my fair share of mistakes. Managing risk/uncertainty is a heck of a lot more difficult in practice than the mathematicians want us to believe. I am only human. I get carried away from time to time like most other investors. Unless you were born with the DNA of Warren Buffett, keeping emotions at bay when making investment decisions is far from easy.

Herding like sheep

However, getting carried away seems to be the norm rather than the exception these days. Maybe it is just me getting older and more cynical, but all around me I see investors chasing the same ideas with little (apparent) consideration given to the elements of risk involved. Find me an investor who is not in love with emerging markets or, for that matter, commodities. I see this sheep-like mentality wherever I turn.

That observation gave me the inspiration to this letter. Please note that I do not provide an enormous amount of detail in this letter (who wants to read a 50 page newsletter?). Rest assured, though, that most if not all of the risk factors mentioned below will be discussed in the months to come.

Now, let’s get started. In the following I list a number of risk factors which I believe investors should give serious consideration, but I do not for one second pretend for that list to be exhaustive. Neither should you read anything into the order of which those risk factors are listed. If you want my assessment of how to rank the various factors, you need to take a look at the risk scatter chart at the end of the letter.

We begin our journey in the high yield space, which is another asset class currently prone to herding; however, I need not look any further than my own parents to understand the urge to invest in high yield bonds. Now in their mid 70s, they are desperate for a bit of income, and corporate high yield provides that better than most other asset classes. Multiply their situation with over 100 million retired – or nearly retired – people in Europe and North America, and you will understand why high yield spreads keep going down.

Click here for the full report.

Source: Niels Jensen, Absolute Return Partners LLP, December 3, 2010.

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