Essay I: “On Investment RISK”

Dreher Capital Management allocates financial assets and makes investment selections based on risk. The underlying belief in this philosophy is that through research it is possible to determine, at least on a relative basis, the risk of an investment. If this is true, investors can control the amount of risk they take by analysis and choice. The firm believes that additional control of investment risk can be accomplished through the use of diversification, which is also a cornerstone of the firm’s investment philosophy. The corollary to this philosophy is that through research it is NOT possible to determine rates of return. Accordingly, in managing investments, it is the firm’s job to help clients take risk efficiently(1). 1. Importantly, the firm does not believe this line of reasoning necessarily leads to indexing, nor does it preclude changing allocations based on perceived market conditions. And, while asset allocation can control investment choices under this philosophy, investment selection based on judgment is not inconsistent with the philosophy.

Investors often ask us what rates of return they should expect from their investments. Our experience indicates this is the wrong question, especially if “rate of return” is measured in short periods of time as is popular with today’s Investment Community. If an investor buys a 7% Government bond maturing in 10 years, for example, what is his “rate of return” the first year if interest rates rise and at the end of the period his bond is selling 10% below cost?

Assuming the purchase price is par ($1000), one might conclude that his “rate of return” for the period was -3% (-$1,000+$900+$70). However, the investor’s stream of income did not change, nor did the amount he will receive at maturity. The only thing that changed was the value placed on the investor’s income stream and maturity proceeds. While this value on a year-to-year basis is beyond the investor’s control, if held to maturity, the investor assures himself a 7% “rate of return,” since he has a contract with the United States Treasury.

In other words, the usefulness of this short term “rate of return,” concept is questionable. What is really important is the amount of risk the investor is taking, which in this case is zero on a nominal basis because his investment is a loan to the U.S Treasury. On a relative basis, the investor is risking the possibility he may be forced to sell before maturity and realize a loss, a risk he can control by purchasing a shorter maturity. Another relative risk in this example is inflation, which would be represented by a reduction of the purchasing power of the investor’s income stream and maturity proceeds. This risk could also be controlled by purchasing a shorter maturity.

Given the above, one might ask why any risk is necessary. If investors purchase only Treasury obligations with very short maturities, wouldn’t both nominal and relative risks be eliminated? Unfortunately for investors, the answer is negative. An investment with no market or fundamental risk would entitle the investor to receive only the rate of return for the day, week or month the investment lasts. Renewal of the investment, such as rolling over Treasury Bills or Certificates of Deposit, would bring the chance of lower returns every time. And this is a real risk. Very few investors, for instance, could stand to see their “rates of return” drop 75%, as the return on short term investments did between the mid-1980’s and the early-1990’s.

At Dreher Capital Management, our conclusion from these observations is that by definition all investment entails risk. Our job, therefore, is to help our clients take risk efficiently: to help them control the risks they do take. We believe that if this job is done properly, our clients will experience a very satisfactory “rate of return,” especially in the long term and regardless of how one chooses to measure it. Since we can’t control investment returns, we attempt to help our clients control investment risk by identifying investment characteristics and employing asset allocation that matches our clients’ investment requirements. In this process, we use the following arbitrary risk classifications to help us develop a risk profile for a given investment portfolio.

We recognize that these risk classifications are arbitrary and that other investors may have different ideas of risk parameters. Regardless of how one decides to categorize investments, we believe that what is important is the use of such a discipline to examine and control investment risk. The following categories, therefore, are just one way (our way) of dividing up the world to help us help our clients.