Recognizing and Rewarding Rational Risk
September 14, 2012
Like beauty, "risk" is often in the eye of the beholder. What might seem "risky" to one person (such as traveling to an exotic destination) might be an exciting adventure for someone else.
It is impossible to completely avoid risk, even in what may be perceived as a "safe" investment. For my team, coping with the uncertainty means having a process in place to manage these risks, and to ensure the risks being taken are recognized, rational and rewarded. During times of market uncertainty and extreme volatility, investors can feel the best risk-management strategy is to sell everything. However, that strategy can carry risk, too.
While that response is completely understandable, it really exposes the investor to significant long-term risks, such as inflation and interest-rate risk. It doesn't allow you to participate in long-term economic growth, and is certainly not conducive to wealth creation. Our process at Franklin Templeton is not focused on avoiding risk, but in fact taking risks-ensuring they are recognized, rational and rewarded.
The three "R's" we use to articulate our core focus are:
Recognized: Risks should be recognized and understood at the security, portfolio and operational levels.
Rational: Risk decisions should be an intended and rational part of each portfolio's strategy.
Rewarded: Every risk should have commensurate long-term reward potential.
Portfolio managers manage risk as they select individual investments and construct portfolios. We supplement the portfolio managers' activities with a team of 75 global investment risk and performance professionals. They are co-located with the portfolio managers in many of our global locations.
Their focus is to take a different perspective on that same portfolio. You can think of it as almost like viewing the portfolio through a different lens-perhaps a quantitative lens. That lens can help identify things in the portfolio that we need to be aware of, and can help ensure any risks are intentional.
The word "rational" can be pretty subjective when it comes to investing, or anything else. As humans, it's easy to rationalize our decisions, even bad ones. But there is a difference between taking risks that are rationalized (which can help us justify almost any behavior) and ones that are rational, which are a sound basis for making investment decisions.
So what does "rational" mean when it comes to portfolio risk?
An investment is rational when it is consistent with the mandate of the portfolio, intentional, not inadvertently arrived at and properly sized in the portfolio.
For example, as a portfolio is built up, security by security, stock by stock, bond by bond, it's possible to gain outsized exposures to a particular attribute like, a country, issuer or a region. As those risk exposures are built up, they can become too large-where it's not an intentional strategy of the manager. Our process is focused on working with the portfolio manager to identify those risk exposures and develop mitigation strategies.
Here's an example of this process at work in a region fraught with uncertainty right now-Europe.
Our Templeton Global Equity Group is finding some once-in-a-generation equity values in Europe. Those values will likely take a patient, long-term focus to realize their potential, but they're consistent with the investment objectives of the Templeton strategies. The managers are eager to seize the opportunity to add them to the portfolio.
The risk management team's role is to help the portfolio team estimate and understand how making those additions might impact short-term performance, to ensure that the portfolio can tolerate the short-term volatility in order to realize value in the long term.
Even the best laid plans can go astray. When they do, a voice of panic inside our heads can drown out all rational thought. As someone who looks at risk and possible "worst-case" scenarios on a daily basis, I have had practice negotiating rationally with that emotional response. But it can be easier said than done at times.
I think all of us have looked back at times where we have had historic levels of market volatility, and recognize those moments when we were staring at the abyss and may have not been thinking through things in a rational way.
There are several keys to maintaining perspective.
The first is going into extreme markets with a well-diversified portfolio. That is the most important feature in maintaining perspective.
Second, having some estimate of how a portfolio might behave in an extreme market before it happens is helpful in keeping the long view. My team spends quite a bit of time and energy on that element.
Last, but not least, it is tremendously important to partner with a firm that has a long-term focus. If you think about the alternative-partnering with a firm that is not well-versed at maintaining that long-term view during difficult markets-you can see how that might contribute to the panic.
Even individual investors can examine risk in their own portfolios by ensuring that they are recognized, rational, and rewarded. There's always some type of uncertainty on the horizon, and if we used uncertainty on the horizon as a reason not to invest, we would never invest. The key is to invest, but with a clear, open-eyed awareness of the risks that you are taking.
Wylie Tollette is a senior vice president and director, Performance Analysis and Risk Management at Franklin Templeton Investments.