Towers Watson is recommending better, broader ways of measuring and monitoring risk, and uses the concept of the “irreversibility of time” to illustrate where standard approaches to risk and return can fall down.
Martin Goss, senior investment consultant with Towers Watson and a member of the Thinking Ahead Group, said that investment is “about an uncertain future that has wide ranges.”
He will present his views at the upcoming Fiduciary Investors Symposium later this month.
“We tend to measure past performance as though the future was easy to predict, but it’s not,” he says. “What we need is a better understanding of risk, including an ability to think probabilistically.”
He accepts a gamble: all of his wealth on the roll of a dice. Roll one and he loses everything, but if he rolls anything from two to six, he doubles his wealth.
“The way we have been trained to analyse the gamble means that we will consider all the possible future outcomes and then weight them in accordance with their probability,” he says.
“In effect we freeze time and take multiple copies of the world and then run the six versions forward as ‘parallel universes’.
“In one of those worlds a one is rolled and we lose all our wealth. But, like an economic forecast, it’s highly unlikely you’ll achieve the expected return,” says Goss.
Investors only get the outcome of one path and some have more pleasant paths than others. The possibility of “ruin” is critical, particularly when the investor is cash flow negative.
There are several implications from this, he says. Time averaging, for example, can help with position sizing.
Understanding the risk can help understand limits on leverage, both within products and within risk-based asset allocations.
“Cash flow is king,” says Goss.
“For positive cash flow the typical arithmetic average is OK, but moving from positive to negative cash flow is a highly non-linear event where this approach can create more problems.”
The Conexus Financial Fiduciary Investors Symposium will be held on Victoria’s Mornington Peninsula from November 25 to 27.