After an upward trend for more than a decade, the first quarter of 2020 has once again made investors aware of the risks associated with equity investments. Although April recovered a good part of the losses, the reasons for this recovery are anything but sound. They are based on the expectation that everything will return to “normality” relatively quickly and that the damage done (economic collapse) can be offset by unprecedented government and central bank support.

Even if the pecuniary losses could be kept within limits, the consequential losses (consumer and corporate behaviour) are still virtually impossible to capture. Moreover, there is a danger that the risks of equity investing are no longer familiar.


Total market

According to CAPT (Capital Asset Pricing Theory), risk is defined as uncertainty or variability of expected returns. It is mathematically measured by standard deviation (covariance between expected and actual return). The calculation formula already shows that this risk can only be captured based on experience. The corona risk, like the tail-end risk in the financial crisis, is not quantifiable, but cannot just be neglected as irrelevant now. In theory, market risk is systemic and thus not diversifiable away. In practice, not being fully invested is enough to reduce this risk.


Individual shares

The risk of individual stocks is considered non-systemic and minimizable, although studies show that 30-50% of their risk is still market driven. Nevertheless, a considerable risk reduction can be achieved through diversification (number of positions). However, studies show that this asymptotic effect is lost from around 35 positions onwards; ideally, 10-15 equally sized equity positions are therefore ideal. Unfortunately, under- and overweighting position sizes leads to hardly calculable results. Optimising the individual coefficients alpha (excess return over market), beta (ratio of return to market) and rho (variability to market) can also reduce the risk profile.


Financial products

Nowadays, there are equity funds for every conceivable purpose, and they are still intended to give the individual investor (retail client) the opportunity to benefit from professional expertise. Unfortunately, there is little evidence that they can beat the underlying index (benchmark) over time, so that the risk analysis is limited to the risk of the benchmark concerned. An exception are closed-end funds, which are not valued daily at net asset value (NAV), but whose price is determined in trading. The fact that this price can in some cases differ considerably from the intrinsic value (premium/discount) leads to additional risk or potential for the investor. It goes without saying that the assessment of fund management is most important, and that it is more important to lose less money when the index is falling than to earn more money when the index is rising.

The most popular fund product is probably ETFs (Exchange Traded Funds). These are exchange traded, usually replicate an index 1:1 and are considerably cheaper than normal funds. Nevertheless, there are some risks that are not so obvious. Although movements in the fund assets must be tracked immediately, the fund manager can use derivatives to reflect the changes and thus introduce a new risk element.  The most liquid parts of the fund are also often “traded”, thereby increasing volatility. As with actively managed equity funds, there are now also “active” ETFs, whereby investments are made in, for example, high-dividend value or growth stocks. Equal weight index products make the most sense in terms of risk, as all companies are equally weighted. This results in “true” diversification, whereby cluster risk like in the S&P500, where the five stocks Alphabet, Amazon, Apple, Facebook and Microsoft together account for a weighting of more than 20%, can be avoided. In the SMI, Nestle, Novartis and Roche account for around half of its weighting.

Malicious tongues claim that structured products were created by investment bankers who were not laid off in order to open up a new source of income for the employer. Even if this is an exaggeration, the “normal” investor is hardly able to identify the risks involved.



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Christian Wagner
Financial Advisor