Nick Samouilhan, Multi-Asset Fund Manager at Aviva Investors, says that when we talk about risk, we need to be very clear about what kind we mean
On 23 September 1999, US spacecraft Mars Climate Orbiter began its descent to Mars. Its mission was to study the climate, atmosphere and surface of our near neighbour, bringing back valuable information for future missions and broadening mankind’s knowledge of our universe. Four minutes into the descent process though and all contact was suddenly lost, with all subsequent attempts to contact it failing.
Such losses are not completely unexpected; these probes need to cover huge distances through punishing environments. However, the cause of this particular failure was far more straightforward. The probe’s software that calculated the distance to the Martian surface worked in imperial units, while the software using these measures to adjust the rockets worked in metric units.
The mistake was in some way easy to make. Both software systems were talking about distance, the only issue was that to each of them this meant different things. An official spokesman subsequently stated: “Our inability to recognise and correct this simple error has had major implications,” the latter term presumably being ‘NASA speak’ for mistakenly ploughing a $300m probe headfirst into a planet.
Using the same term but having differing thoughts on what it means is a common problem. In our industry, the term “risk” is a case in point. For instance, we talk about how much risk is in a portfolio, if investing in Greek bonds is worth the risk, or how much risk a client can take. The risk of a client not being able to retire when she wants to is another one.
Note how risk is interpreted quite differently in each of the above four uses of the term. For example, when discussing portfolios risk usually means volatility, while the risk of a particular investment (such as Greek bonds) usually means the probability of losing money. In addition, a client’s risk appetite is usually viewed as being how much loss they can stomach. Finally, the risk of a client not meeting their savings goal usually refers to the expected returns of the client’s portfolio. All the same word, all very different meanings.
Like the Mars probe, it really is important to focus on what is really being spoken about. When you profile a client’s risk appetite and match it to a portfolio, for example, does she/he understand the risks of the portfolio and are you both talking about the same thing? Is it the volatility of the portfolio, the risk of losing more than 20 per cent, or the risk of not being able to retire at 60?
The different interpretation of what risk means matters. It is, for example, entirely possible to run a low-volatility fund and lose substantial amounts of money over time. It just means losing money steadily and consistently. Here, it is not hard to imagine a disappointed client when based on one interpretation of risk their portfolio would be a low-risk offering while on another it would be a high-risk one.