With the Formula One (F1) race back in Singapore, there is huge excitement in the air for this adrenaline sport.
Beyond the race, F1 is about pushing the boundaries of speed. F1 drivers navigate a precarious balance between speed and safety. Racing legend Ayrton Senna famously said, “if you no longer go for a gap that exists, you’re no longer a racing driver.”
Nevertheless, winning the F1 race is more than just chasing speed and performance. Winning or losing the F1 race is almost entirely about managing risk.
Managing risk in F1 is paramount – as in investing, as both must evaluate the potential rewards against the likelihood of negative outcomes.
How does one manage risk? By using data to make risk-informed decisions.
An F1 car has more than 100 sensors that monitor some 10,000 components, giving feedback on all sorts of data such as tire pressure, fuel burn and brake temperature, etc.
Data feeds into the team’s data centre, which in real-time, together with the driver, assesses how to make the optimal risk-informed decisions.
Taking emotions out of investing
Investors would do well to take a risk-informed approach as well. Without data, investing based on emotion - greed or fear - is the main cause of why so many people are buying at market tops and selling at market bottoms.
During times of market euphoria, some investors, due to the fear of missing out (FOMO), rush into a toppish market, underestimating the risks associated with investments and making suboptimal decisions based on emotions.
Similarly, during times of market sell-down, due to fear and risk aversion, some investors may be unwilling to take on calculated risks.
Therefore, one of the ways to remove emotions from investing is to adhere to principles like portfolio diversification and regular rebalancing.
Ideally, the investment process should be done by a team of investment professionals, which helps in taking the emotions out of investing, just like a world-class F1 team, with set investment objectives and risk limits.
Diversification, Rebalancing and Long-term View
Financial markets and asset class performance can vary significantly over time and is difficult to predict. Strong performance in a given year can be followed by significant underperformance or even painful drawdowns in others.
Taking a long-term view and remaining invested in a broad range of asset classes across the investment cycle is a time-tested strategy. A diversified portfolio is more efficient than single asset classes. If two assets with the same long-term return and the same volatility are on offer, a portfolio with both of these assets will have the same return but likely with lower volatility – the only free lunch in investing.
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Attempts to time the market without a diversified portfolio as an anchor often result in oversized, risky bets on very specific market outcomes. In this process, investors potentially fall victim to emotionally charged decisions.
Remaining fully invested in a diversified portfolio over the market cycle is the most reliable and consistent method for successful long-term investing.
Importantly, well-diversified portfolios tend to have lower probabilities of sharp losses or drawdowns over the business cycle. Even well-diversified portfolios can suffer temporary losses, but they tend to recover in the medium to long term. Shorter investment periods increase the probability of negative rolling period returns, while investing in higher risk portfolios also naturally raises this probability.
However, economic conditions and valuations will evolve throughout the market cycle. For this reason, it is important to re-optimize the portfolios regularly. The process of portfolio rebalancing imposes investment discipline by triggering rebalancing from parts of the market that have rallied into those that have lagged or fallen in value. If followed consistently, rebalancing allows investors to ‘buy low’ and ‘sell high’, enhancing the total portfolio returns over the long term.
Racing ahead: Modernizing investing
The word “risk” derives from the early Italian word "risicare", which means “to dare”
Investing is not just about daring to take risks, but also on managing risks.
Managing risk is about seeing the world in range of potential outcomes - the good and the bad - and attaching probabilities to them. It is using data to help investors with the probabilities and possible actions.
Risk management is maximizing the areas we know about and have control over while minimizing the areas where we have no control or know little about.
When it comes to asset allocation construction, data can be used to optimise the asset class mix, considering asset classes correlation, risk, focusing on how much risk the portfolio is allowed to have.
F1 has a clear set of performance metrics — lap times, average speed, etc. — that teams use to measure their success. Investing relies on metrics such as return on investment, compound growth, correlation, volatility, and risk-adjusted returns to gauge the effectiveness of financial decisions. These metrics guide decision-making and allow for objective evaluation.
On an individual security level, there is a need to use data analytics to better understand the risk exposure in portfolios. The risk behaviour of an individual security has to be interpreted in a portfolio context by assessing how the risk exposure changes over time and examining the concentration risk of the investment across sectors, issuers, and geographies.
Stress testing is a useful tool to test portfolios against hypothetical or historical “black swans” events. Stress testing is a good exercise which uses big financial shocks to assess the resilience of portfolios.
For example, investors can use historical shocks such as the Global Financial Crisis to stress test their portfolios. Investors can better see the risk and vulnerabilities from such an exposure, and gauge if there is an overexposure to any risk-types. By doing so, investors can have a better appreciation of the underlying fragilities embedded in their investments, allowing investors to make fast and precise adjustments.
Just like in F1, the use of data will help investors have an informational advantage to make better investment decisions.
F1 and investing is a team sport
Make no mistake. F1 is a team sport. F1 teams consist of drivers, engineers, strategists, and mechanics, all working together for victory. In the same vein, investors often collaborate with financial advisors, analysts, and researchers to make informed decisions.
In F1, teams must choose the right tire strategy, fuel load, and pit-stop timing to maximize their chances of victory. Similarly, in investing, individuals must make choices about asset allocation, risk tolerance, and market timing to achieve their financial goals. Just as a F1 team evaluates race conditions, investors must analyze market trends to adapt their strategies for optimal outcomes.
Investing should be managed just like in a professional team sport. A good and reputable team can professionally construct a diversified portfolio that suits your investment objective, with the least amount of risk possible, rebalancing regularly, making tactical shifts when the environment changes, and exploring the entire investment universe for opportunities.
By understanding and applying the lessons from F1, investors may strive for success on a different kind of track.
A contribution piece by James Cheo, Chief Investment Officer, Southeast Asia, HSBC Global Private Banking & Wealth.