Managing the Unmeasurable — Where are My Risks?

Posted on October 16th, 2012 by

Investors for decades have equated risk with volatility. But as we learned in the most recent economic crisis of 2008-09, unseen and external factors can wreak havoc on portfolios.

So, what do we investors do with our new found concern over risk?  If the past is any guide, we dutifully build our concern over those past risks into our portfolio thoughts and allocations (knowing full well that the past seldom repeats itself in exactly the same way…)

THAT is a recipe for failure.

So, what risks are we missing?  What actions should we be taking now to protect from those risks?

There is a new school of thought called Integrated Risk analysis that refuses to ignore risks just because we can’t quantify them. Take ecological risk:  We know that society is consuming more of the earth’s resources than it can replenish.  Our activities are even inhibiting the planet’s ability to produce at the earlier rate and same cost.  And we are painfully learning that the available quantities of potable water and arable land are insufficient to support the growth forecasts that underpin our valuations.

Something in this equation is incorrect — either valuations or growth — and as fiduciaries, we have a responsibility to manage this risk.

Sustainable investors inherently execute an Integrated Risk model by attempting to incorporate non-financial factors (such as the ecological limits of the planet) into their analysis.  Unfortunately, there is no simple model to account for these issues.

The complexity of the problem is seen in the breadth of potential impacts:  Price changes lessen demand for certain products, while higher tariffs may be levied on the production of others.  More frequent extreme weather events can impact output levels, while shortages and higher prices can lead to geopolitical upheavals.  Every investor inherently perceives these risks to be present, but is at a loss to account for them.

Boardwalk Capital attempts to account for these “externalities” not by predicting them, but by selecting securities within each sector that are least exposed to these elements. (Companies with lower raw material intensity, greater efficiency, etc.)  We want to see companies address these risks and lessen them for investors.

We also think that by doing do, we are funneling capital to the most productive areas, making our investments more part of the solution than part of the problem.

In the selection process, we also focus on companies who have built brands on quality and service, and are less exposed to activist consumers’ changing tastes.  We identify companies whose governance standards make them less likely to run afoul of laws, and regulations, and ethical standards. Again, attempting to lower risks to the investor.

Will this eliminate these external risks?  Of course not.  But taking imperfect, partial steps is greatly preferred to ignoring the issues entirely. They are not going away, and as time goes on, “externalities” eventually become “realities”.

The opinions expressed in this article are solely those of the author, Scott Sadler, Boardwalk Capital Management.
For more information, discuss this topic with your advisor or visit Boardwalk Capital Management.

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