PRIVATE CREDIT
Aura Private Credit Weekly Insights - 18 November
This week, the wage price index demonstrated that real wages are struggling to keep up with the rate of inflation
Risk tolerance can broadly be defined as the level of risk an individual is willing to accept. For an investor, the “known known” may mean how much one is willing to lose.
Risk tolerance can broadly be defined as the level of risk an individual is willing to accept. For an investor, the “known known” may mean how much one is willing to lose.
For example, if you invest $100, are you willing to accept the risk of a capital loss of 20%, reducing that initial $100 investment to $80? Are you prepared to accept a lower return over the short term, but rely on compounding returns over the long term, hence minimising volatility? Do investors assess that risk by asking shorter, more detailed questions, such as what are the short-term to long-term cash liabilities, return expectations or time horizons for investing?
At a high level, there are a handful of categories that fund managers use to divide multi-asset products based on risk. Five of the most common categories are high growth, growth, balanced, moderate and conservative. Marking a product as high growth versus conservative will be dependent on the percentage of risk assets, such as equities, versus defensive assets, such as government bonds. Each product would then define the allocation ranges at which a portfolio may be exposed to both risky assets and less risky assets.
Managing the Known Unknowns versus the Unknown Unknowns
As an investment manager, our philosophy through some very tough learnings over time is to focus and position for the known unknowns, that is, taking into account the apparent risks that the data is showing. While it is true that data-driven risks may not always impact the market the way that investment managers expect, reflecting these risks within the portfolio construction helps navigate uncertainty.
Considering current market conditions, we believe re-addressing risk tolerance is vital. Over the past two months, the banking system has elevated market risks. With three banks collapsing and one major global bank requiring rescuing, the known risk has played through, where this may eventuate continues to be an unknown unknown. Similarly, inflation and yield curve convexity are just as salient, as these may have impacts across other asset classes, e.g., commercial property.
Having a disciplined approach to risk management and being well diversified with active management of portfolios is always important and is especially crucial at this part of the market cycle. Regularly scenario test your portfolios through major drawdown events and sense-check the outputs against your risk tolerance. While the unknown unknown may result in different inputs for your scenario tests should it play out, it is still a valuable gauge of risk management.
Being vigilant and retesting your investment strategy by reassessing your risk tolerance, return expectations and time horizon should be an ongoing exercise.
