Superannuation funds and other institutional fund managers need to rethink their approach to risk in light of the prolonged financial crisis, according to Watson Wyatt global head of investment consulting Roger Urwin.
"People are looking back now and realising they weren't adequately prepared for what has happened and they are asking how can they be better prepared in the future," Urwin told delegates to the consulting firm's Ideas Exchange conference in Melbourne last week.
Many of the old rules and assumptions had been overturned by the events of the past 18 years, he said.
Volatility levels have been shown to be 50 per cent higher than expected, while the concept of 'value at risk' has been shown to be inadequate as a way of dealing with events beyond the one in 20-year scenarios normally modelled.
In addition, the issue of counterparty risk has been underestimated by many funds - leading to a heightened exposure to transactions with other parties that later become unable to fulfil their obligations.
To manage future risk it was essential investment committees and chief investment officers be clear on what was understood by risk, Urwin said.
Risk should be measured and goals should be explicit, for instance, but it should also be understood that risk is not just a number. More attention should be paid to the possibilities of extreme scenarios beyond the statistically expected.
It might also be necessary, given the rapidly changing investment environment, for investment committees to take a shorter-term dynamic review of investment opportunities.
"In the past, best practice may have been to have a strategic view every three years, but in light of the recent market conditions we should perhaps allow for annual and even intra-year reviews," Urwin said.
In order to make decisions with a fully-informed macro view of investment opportunities and risks, it might also be appropriate to draw on additional specialist external assistance, he added.
Ultimately, however, it was essential for investment committees to find a better balance between risk and return, he said.
"Everyone agrees they need to be balanced, but they inevitably concentrate on maximising returns because it's more exciting. But we need to better understand risk in order to be able to tame it in these kinds of conditions," he said.
