MDUDUZI LUTHULI: Risk insight separates clients from investment managers

The eternal fight between client and investment manager is that clients want certainty from a field that thrives on uncertainty. Clients want high returns without the risk, while investment managers understand that high returns are a result of embracing risk. The great divide comes from a misunderstanding of what risk is.

One thing my career has taught me is that if you want a client to invest for the long term, you need to define the term “risk” for them. Explain the rules of the game so that the client can decide if they want to play.

“Risk” is commonly used by investors, but when you ask them what it really means, you get shrugs or jargon. We grab onto things such as volatility, drawdowns or “permanent capital loss” because they are easy to measure, not because they appropriately or fully define risk.

You don’t need to precisely calculate or define risk to make good investment decisions. Rather, the calculations are there to help us understand the term more intuitively so we can manage our behaviour and bias when making those decisions.

Academic Elroy Dimson put it best when he said, “Risk means more things can happen than will happen.”

That is the core of it. Risk is uncertainty. It is deciding about an unknown outcome. When you decide, you are staring at a bunch of possible outcomes, with no clue which one is coming or how likely it is. It is not about the choice being bad, but about not knowing what is next.

Imagine I hike up Table Mountain in winter, but I take a lesser-known trail with no map or water. That is high risk. I might make it to the top (possible, but tough), or I could get lost, dehydrated, or worse (more likely). The outcomes are wide-ranging. Now, if I try to climb straight up the mountain’s sheer cliffs without gear, that is not risky — it is a guaranteed disaster. The outcome is known.

Bad possibilities

Risk comes from uncertainty, not from the decision turning out to be foolish. Investors need to focus on the spread of possible outcomes and what the odds might be. We often do this naturally in life — our gut guides us — but rarely is our money on the line. So, when investing we seek a simple number (definition), and we love numbers (certainty), even when they don’t tell the whole story.

When markets are volatile, as they have been recently due to US President Donald Trumps’ tariffs, it feels like danger is everywhere. We get nervous, maybe pull back. Why? We start picturing a wider range of outcomes — everything feels as if it could and will happen. We give more weight to the bad possibilities. This isn’t just us overreacting. Our brains are built to let what’s happening now shape how we see the future. When stocks are swinging wildly, we think that is how things will stay indefinitely. In a market plunge, it is easy to imagine more bad news, so we act as if it is coming.

In a market bubble everything is soaring, and people are buzzing with excitement. We start to believe only good things are possible. The range of outcomes we think about narrows to just the happy ones in which we become overnight millionaires, and we act like they are a sure bet. Bubbles are about chasing hot trends and buying into hype, but they are also about ignoring risk. The danger is growing, but we are too caught up in the party to care.

How long you plan to hold an investment can turn risk upside down. People say long-term investing is “less risky” than short-term investing, but what does that mean?

If you put money in stocks for one year, the possibilities are huge — up 40%, down 40%, not out of the question for a broad index. The chance of losing money isn’t small either. Stocks are more likely to go up than down in a year, but it is no lock.

Now stretch that to 30 years. The range of outcomes shrinks, and the odds of making money get much better. I would feel good betting on stocks over three decades, but not over 12 months. Why? In a year, stock prices are driven by market mood swings. Over 30 years, it is the slow, steady growth of company earnings and reinvested profits that take over.

But longer isn’t always safer. If your strategy could crash and burn — like if you are borrowing heavily or betting everything on a few stocks — time works against you. A portfolio with just three stocks is a wild card with a huge range of outcomes. Holding it for 10 years is much riskier than one day. Time only helps if your approach isn’t flirting with disaster.

Shaping a portfolio

Diversification is like wearing a helmet when you bike — not foolproof, but it helps. By mixing investments that don’t move in sync, you can narrow the range of what might happen. Going from one stock to 50 means you are less likely to strike it rich, but you will also not lose everything. It is about shaping a portfolio with outcomes you can live with.

When people gripe about “overdiversifying,” they mean the portfolio is so spread out it is predictably stuck in averageville. But there is no perfect amount of diversification. It depends on how much uncertainty you are OK with. Want a shot at a big win? You will have to stomach the chance of a big loss. Prefer steady? Spread your bets.

Risk isn’t just about what could happen, it is about what you are putting on the line.

A risky move might not matter if the stakes are tiny. Betting my whole salary on a coin flip is a different kind of risk than tossing in a rand. The coin’s odds don’t change, but what it means to me does. Good investing means knowing the range of outcomes, guessing their odds, and deciding how much you are willing to risk.

What does good risk management look like? It comes down to the following principles:

• Get a sense of the outcomes and their odds. You will never know exactly, but you can make educated guesses;
• Lower the chance of a wipeout. Stay away from traps such as betting everything on one stock or piling on debt; and
• Boost the odds of good results. Diversification and long time frames can tip the scales.

This stuff is hard because we are human. Our brains trip us up. We overreact to what is happening now, get too confident, or fixate on what is fresh in our heads, and we lean too much on metrics that try to boil risk down to one number, which is like summing up a book with a single word. It doesn’t work.

The future is a big question mark, and more things can happen than will. Keep that front and centre, and you will make better calls with your money. When we are living with markets in each moment it is almost impossible to separate signal from noise because of the undue status we place on the present.

Aside from entirely ignoring the vacillations of markets (which for many is impossible), the only conceivable way to deal with this is to define in advance what aspects are important and try to ignore the rest. This is the price of admission for the advantages provided by a long-term investing approach.

Nobody said it was easy.

• Luthuli is investment management director at Luthuli Capital.