Risk & Return
Your risk tolerance and the return you require or expect from your portfolio are two primary considerations when designing an investment strategy.
When discussing risk, ensure that your financial advisor has the same definition that you have. Most financial advisors think of risk in terms of volatility, but many clients think of risk as maximum expected amount of loss. The two definitions will not necessarily lead to the same type of investment strategy.
Portfolio returns can come in several forms: Capital gains, dividends, and interest. If you are subject to taxation on your investments, then it is important to consider after-tax returns. Equally important is to account for inflation. You can earn a practically risk-free rate of return in a money market or savings account, but you may actually be losing money in terms of buying power if the interest you earn after taxes does not keep up with inflation.
There are specific forms of risk inherent to every investment, but generally risk can be broken down into that associated with the individual holding (unsystematic risk) and that associated with the market as a whole (systematic risk). There are also important broad-based risks that affect certain types of investors more than others: For example, currency risk for people investing in one currency but spending in another, or interest rate risk for investors whose portfolios contain significant amounts of bonds and other fixed income investments.
Risk & Return Considerations:
Unsystematic risk
If your investment loses value while similar investments gain value, then you are a victim of unsystematic risk. This type of risk can be mitigated through diversification. If your portfolio is properly diversified, then a loss in one position due to unsystematic risk will be offset by gains in other positions.
For an investor with a small portfolio, diversification can be provided through mutual funds, exchanged traded funds, or various other pooled investments. For an investor with a larger portfolio, diversification can best be accomplished by carefully chosen individual holdings.
Systematic risk
If your investments lose value because of a general decrease in the value of all similar investments, then you are a victim of systematic risk. In years 2000, 2001, and 2002 the share prices of many US technology stocks fell in value – this was an example of systematic risk in the technology industry. In 2008 and 2009 practically all investment markets lost value except US Treasuries and the US Dollar – this was an extreme example of systematic risk.
Systematic risk can be controlled using asset allocation to some extent but a market neutral strategy or various other forms of hedging will probably be more effective under such circumstances. More information is available in the “strategies” section of this website.
Risk tolerance
At IAM, we find that the best way to determine a client’s risk tolerance is to thoroughly understand their investment needs and goals. For example, a retired person may be a daredevil in real life but if they are dependent on their portfolio for income, then their investment risk tolerance may be quite small. In fact, the level of risk an investor may be willing to take may not appropriately reflect his or her financial situation.
Before giving advice on investment matters, we ensure that we have an in-depth understanding of your situation. An analysis of how your portfolio would have performed historically over various difficult investment periods is performed so that you are aware of the amount of financial risk to which you would have historically been subject. Although historical returns may be quite different from future returns, at least this method can serve as a starting point for risk management and the basis for a Strategic asset allocation.
For some investors a Strategic asset allocation is enough, they intend to buy-and-hold and ride out the rough patches trusting that over the long run the asset allocation will give them the returns they expect. This is a valid strategy and much research has been devoted to the benefits of such a passive investment strategy vs. more active strategies. For this type of investor we recommend our Portfolio Advisory service.
However, we do recommend going beyond just a Strategic asset allocation to also incorporate Tactical portfolio changes based upon the current economic and investment conditions. As an example, at times of low interest rates, perhaps it makes sense to underweight fixed income investments. Or when there is froth in the real estate market that is usually a good time to be more cautious and perhaps re-allocate elsewhere.
Diversification
An investor whose portfolio consists of shares in 100 different technology companies is probably not as well diversified as someone who holds shares in only 10 companies, each in a different industry group. A properly diversified portfolio is diversified regionally and in terms of asset classes and industry groups.
Useful diversification depends upon the lack of correlation between the returns of the portfolio holdings. You always want to hold investments whose returns will be positive in the long run, but you will have a less volatile portfolio if the returns on investments in one part of your account outperform at a time when another part of your portfolio lags.
It should be noted that most portfolios do not contain meaningful diversification except to the extent that some of the money is in stocks and some in bonds. Many investment advisors will tell their clients that they have diversified the portfolio by putting some money into US stocks, non-US stocks, value and growth stocks, small and large-cap stocks, and emerging market stocks – the reality is that all of these markets are very well correlated and offer little diversification.
As part of our research at IAM, we measure the historical correlation between various investments and asset classes and help control risk by choosing holdings that we expect will have attractive returns but that are not well-correlated. Furthermore, since correlations can change with time, we monitor our clients’ holdings so as to ensure their portfolios remain well-diversified.
Currency risk
If you are spending your money in a currency other than that of your savings then you are assuming currency risk. Emerging markets tend to have volatile currencies but even in developed markets currency risk can be substantial. As an example, the US Dollar weakened vs. the Euro by about 50% from 2000 to 2008, representing a substantial decrease in purchasing power for someone spending their money in Euros but investing in US Dollar denominated assets.
Interest rate risk
At a time of historically low interest rates, a major risk to many conservative investors is interest rate risk. When interest rates rise, bond prices fall and many conservative investment portfolios contain significant holdings of bonds, and even worse – bond funds. With discrete bonds that have a maturity date at least you know what your risk is since at some point the bond matures and you get your money back – but with most bond funds there is no maturity date and so no bottom to the risk assumed. Couple this with the fact that in the period from 2008 to 2012 a great deal of money has flowed into fixed income investments, and there is the potential for a considerable selloff in this asset class once signs appear that interest rates may rise.