The risk factors

Great investing requires both generating returns and controlling risks. And recognising risks is an absolute prerequisite for controlling risk.

Investment risk is largely invisible before the event – unless you have some unusual insight – and often still murky after the event. Most financial disasters have therefore occurred due to the failure to foresee and manage risk. This occurs because, risk only exists in the future and we all know it is impossible to know what the future holds. There does not seem to be any ambiguity when we view the past as only the things that happened, happened.

Understanding, identifying and controlling risks are extremely important components of strong portfolio management.

Investors tend to overestimate their ability to gauge risk and understand the mechanism of events they have never seen before. In general, humans do not have to experience something to know if it is dangerous or not, but for some reason, during bullish market periods, investors do not perform this function of identifying risk prudently. Instead, they tend to overestimate their ability to understand and foresee the complex financial market’s web, especially with new information coming in each day.

So the question remains, how do you measure risk? To put it simply, it is nothing but a matter of opinion. You can have an educated and hopefully skilful opinion or estimate of the future we see, but it is still an estimate.

Source: Howard Marks – The Most Important Thing

Implications of the US AAA rating downgrade by S&P

Last week, our view was that the AAA rating for the United States will hold for the time being if the debate over the debt ceiling is resolved. However, this week’s downgrade by ratings agency Standard & Poor’s from the AAA to AA+ rating was unexpected.

So what does this mean for markets over the short to medium term?

The short term impact is being felt around the world now with markets falling heavily. The downgrade was unexpected and the repercussions on investor’s psychology have been enormous. The main difference between 2008 and the current turmoil is that the credit market is still functioning. It appears that the current fear has been predominantly caused by two factors including:

1.    fear of another recession in some developed economies; and

2.     a crisis of competency as markets question the ability for policymakers in Europe and the

       US to effectively deal with their respective fiscal challenges.

In the medium to long term, the likely impact to the borrowing costs of the US may be fairly minimal unless more downgrades are made. The greater concern is the impact of weaker economic activities and for consumer confidence. The full implication is still hard to determine at the moment. As such, we believe many investors will take selective opportunities and the rest will likely remain on the sideline.