The funds-management industry can learn from the way airlines manage risk.
The funds-management industry can learn from the way airlines manage risk. Airlines have a straightforward mission: transporting their passengers safely from A to B. It's a mission they take very seriously, says the head of investment services for industry consultants Towers Watson, Graeme Miller.That's because the consequences of failure are specific, immediate and obvious, Miller says, and if they miss their target by even a small margin, the consequences are just as devastating as missing it by a large margin.Superannuation fund members, too, want a safe journey to financial security in retirement, but their less-experienced pilots, in what is a relatively young industry, have a different approach to risk, he says.In some ways that's fair enough, he says. "Flying a plane, essentially, is all about avoiding risk. There's no reward for taking risk. But investment is, in fact, a risk-seeking activity - you're seeking to take risk and be rewarded for doing so, but in a measured and controlled way."However, the question being asked in the wake of the global financial crisis is whether the investment industry has been too focused on the mechanics of measuring risk and not enough on understanding risk itself. There's also discussion about the difference between "risk" and "uncertainty" and whether ordinary investors have been left thinking risk management addresses the latter."We need to be careful not to mistake measurement for understanding," Miller says, quoting The Wrong Type of Snow, a report Towers Watson released this month. (The title refers to the excuse a British rail executive offered for failing to keep the trains running one winter.)"To understand risk, you need to have a very clear understanding of what your mission is," Miller says.If a fund manager sees their mission as making sure their products are competitive with those of their peers, "even if there's a strategy that might reduce the likelihood of loss for members, having a strategy that's different might be viewed as risky," he says.But if a super fund's mission is clearly described as helping members achieve financial security in retirement, how that fund performs in the short term versus other funds will be less important than its progress towards that long-term target.Understanding the risks they face, airlines build in buffers, Miller says. There's a large amount of "redundancy" built into any one flight - dual pilots, multiple engines, back-up systems and carrying more fuel than is needed."In investing, we don't tend to build a lot of redundancy into what we do," he says."When savings plans are formed, there'll be an assumption made about the central expectation for investment returns," he says. "If there was a bit more redundancy, perhaps in the form of more contributions being paid in, it would recognise that central outcome is not always going to be achieved."After all, we don't dream of filling a plane with just enough fuel to get to its destination."Scenario planning and stress testing are other useful concepts. "When you get on a plane, the pilots and crew have been through thousands of hours of scenario planning, stress testing and emergency simulations," Miller says."They model what their behaviours might be in an emergency they try to remain calm under pressure and they execute a plan that's well rehearsed and well documented."Towers Watson says managers should take a "dashboard" approach to risk. In the cockpit, pilots monitor a multitude of flight instruments likewise, fund managers should be wary of focusing on just one type of risk.