Culture of risk vs. culture of opportunity: When things are going well, it’s all about taking advantage of opportunities. When things are getting worse, like they are right now, we pay more attention to risks. This is how things work. They shouldn’t, though. We should always build and work in a culture of taking risks.
During the five years I was the chief risk officer for the University of California pension and endowment, the CIO Jagdeep Bachher and I started a programme to create a risk culture. Taking care of risks and looking for opportunities went hand in hand. One of our annual reports could, in fact, be opened in two different ways. On one side of the annual report’s cover, the word “opportunity” was written. When you turned the report over, the word “risk” was written in the opposite direction on the back cover.
A pension helps people reach their financial goals. At the University of California, this includes more than a quarter of a million people and a portfolio worth more than $150 billion. The programme we built there has lessons for the advisor who works with one person at a time. So, here’s what I mean by “risk culture” and how it can be used in designing portfolios and making decisions about investments.
Risk Culture Is Human
Risk is not a number; it is a story that ties together the client’s portfolio and goals. Quantitative measures are a dead end for people who are only interested in one aspect of returns, but a person is multidimensional and has many goals in life, such as building a solid foundation of financial security, keeping a comfortable lifestyle in retirement, and maybe even reaching for more ambitious goals.
The language of risk culture is the same
A culture is built on a shared language and way of talking to each other. So, as a starting point, risk culture means making a common language for measuring and evaluating risk. The usual way to talk about risk is to talk about risk factors. These represent risk in a way that is clear and easy to understand. Often, a small number of risk factors can explain over 90% of a portfolio’s non-idiosyncratic risk, even if it has hundreds of assets.
And using the same language means that the CIO, the advisor, and the client all use the same risk application and risk metrics. And doing this beyond the risk application by having the same data, data tags, and data schema from the core performance reporting system to the applications that use that data.
Saying the same things about risk is more than just saying the same numbers. It’s about telling stories about risks and explaining how they might change and how they will affect the client’s portfolio and life decisions. Example: I’ve been the chief risk officer at many different institutions. When there was a risk issue—and it didn’t have to be a crisis—the CEO, the CIO, and the heads of the trading areas would all sit around a table with me. We had risk reports to look at, but most of what we talked about was stories and what-ifs about how things might go. One person might finish the other’s sentence or add to the story based on their own experiences and markets.
There is a risk culture
A culture does things. To be important, you have to do something. If nothing is done, it could be called a risk ritual. When we made a portfolio, changed it, or thought about a new investment, risk was at the top of the list. For portfolio design, this means looking at the portfolio in terms of how exposed it is to risk factors, to see how small changes affect the portfolio, and to see how exposed it is to sectors, countries, and investment styles. Risk factors are very important for this because risk isn’t always clear when you look at each asset individually. Amazon’s main business is selling things, but it also makes money from cloud services, which adds to its technology risk factor. Equinix is another good example of a cloud service. It is a specialised REITS real estate company, but its main business is running data centres.
For private equity or real estate deals, this means looking at how they fit into the whole portfolio, not just how risky or profitable they are on their own.
Risk culture changes over time.
I think about risk in terms of culture because, like culture, risk is an essential part of what it means to be human. We learn from our mistakes, we try new things, and we make things. We have different tastes, different life situations, and different priorities when it comes to the different investment goals. For example, a client with a young family who is trying to save money will have a different focus on security than a client who has raised their children and has a lot of money. And this has to be at the heart of how we think about risk, especially the risks that matter for people over a longer period of time.
The way people live changes as society changes. Risk does as well. So, the point of view is more about the culture of risk than the rules of risk. This shows why it’s important to have a flexible approach to risk that takes into account change. A culture is a defence against the surprises that come up because of the way market risk works. Taking care of these with the same mindset and understanding.
Risk culture looks at the big picture
As risk culture becomes a natural part of the process of being a financial advisor, it adapts to the client’s time frame. People who own assets tend to have different time frames than those who invest their assets. Because of this, things like climate change and population growth are more important than the performance of asset managers and hedge funds, which are measured in months. Some risks that are important to these institutions are just noise to those who look at things over a longer period of time.
Advisors and their clients now know that picking stocks and trying to get alpha is usually a pipe dream. There may be rare opportunities, but they usually come with a fair amount of risk. As a result, the new direction for wealth management is to shift toward a focus on risk. This means making portfolios and judging investments based on market risk and the client’s goals. Portfolio risk evaluation tools are a good place to start, but they show the most when they are used in the context of a risk culture.
