Factoring in risk may help us avoid past investment mistakes

LIFE is a risk. The concept is hardly novel but the quantifying of risk is, either consciously or subconsciously, one of the primary dictators of behaviour.

Every one of us faces risks every day, from crossing the road, the threat of food poisoning, to the possibility of a pandemic delivered by a snuffling pig or a sneezing budgie.

In the world of investment, we practitioners are rightly obliged to ensure that any prospect that we recommend to a client is appropriate to their risk profile. The trouble is that risk is not a constant. Not that long ago, Enron was a bastion of financial prudence and respectability, a haven for investors, for employees and their pensions; it went bust. The destruction of the Scottish banks, which, even three years ago, would have been quite unthinkable, has altered the risk profile fundamentally. Recommending a client to buy Royal Bank of Scotland shares five years ago was regarded as an obvious defensive move; today, it would be rank speculation.

Of course, for every risk there is potentially a reward. For example, in recent weeks I have seen a significant increase in investor interest in the various companies involved in exploiting what are believed to be the hugely valuable reserves off the Falkland Islands. Some of these companies will be successful but many will not, expectation a long way from commercial reality.

Harry Markowitz, a US Nobel Prize winning economist and regarded as the father of modern portfolio theory, may be able to shed some light on the issue. His views have been questioned recently by those who put greater emphasis on behavioural economics. They argue that decisions are often the product of psychology, where it is believed that past trends can be a precursor of future events, but his theories remain highly persuasive. Markowitz's modern portfolio theory attempts to maximise return and minimise risks by testing the variation of any asset class to a standard and use this variation as a beta – the higher the figure from the core, the greater the risk.

By analysing the variations of each asset class, it is argued that a portfolio can be tailored to a client's risk profile. At the centre of Markowitz's theory is the need for diversification, incorporating into a portfolio a range of asset classes which, together, would secure a risk profile appropriate to an individual's wishes.

It is important to appreciate that these theories are all relative. If the market falls, so will an investment portfolio, the application of the theory only dictating the extent to which that decline matches the overall market trend. Similarly, in any upturn, conservative portfolios will make less progress against the market than their more racy counterparts.

Some argue that the collapse of western banks had such a devastating effect because the banks had strayed away from Markowitz's theory of diversification to concentrate on generating the maximum amount of revenue from a very limited financial arena largely predicated on debt and property.

Understandably, legislators and regulators are now attempting to put in place a structure which will ensure that the recent disasters within the lending institutions will not re-occur. It is a fond thought, but any student of the human condition will not be persuaded.

Banks should be boring and they probably will be for some time, once the political posturing has faded, but I have little doubt that somewhere in the future history will repeat itself. Investors should heed Markowitz's teachings and never be over-exposed to a single asset class, however promising that prospect might appear.

• Bryan Johnston is a senior divisional director with Brewin Dolphin