Risk Management

What is risk management and what role does it play in portfolio construction?

All of us deal with risk every day, in every decision we make. We constantly reassess risk in our lives by replaying situations in our minds and asking ourselves if we made the “right” decision. When it comes to investment accounts, most people associate risk a potential loss to their principal or the volatility of an investment. Both can give pause. But not all risk is bad. In fact, by blending different types of investments, you can lower the overall risk in your portfolio and possibly experience higher returns.

Although each of us approach risk differently, there are several types of risks worth mentioning. Most portfolios have three main types of investments: stocks, bonds, and cash, but even the safest investments, like CDs, have risk associated with them.

CDs are very common for people who are uncomfortable risking any amount of their principal and want to minimize their market risk, or the fluctuation of their investments due to market conditions. And yet there are other risks associated with CDs, including opportunity risk, reinvestment risk, liquidity risk, and inflation risk. Opportunity risk means that you could have achieved a better return with a different investment. Reinvestment risk is not being able to invest that money at the original rate of return and a valid concern when investing in fixed income securities. An example of reinvestment risk is what happened to CD rates in 2008-2009. During that time, one year CDs were paying close to 5%, and approximately one year later theywere paying 1% (and stayed there for several years).

Different investments, like stocks and bonds, carry different risks. Many people own stocks and bonds through mutual funds. Some people also maintain alternative investments, like private real estate. Stocks and bonds usually have an inverse relationship, meaning that one will rise while the other one declines. If an investor wants some protection against a stock market decline, they blend stock and bond investments together. By balancing different investments, it is possible to achieve the desired
returns with less risk. The percentage of each should be discussed with your financial advisor to determine a portfolio that allows you to reach your goals. There also needs to be a process to review the portfolio periodically and make necessary adjustments.

Concentration risk occurs when a single holding (or type of investment) becomes a large part of your overall investment portfolio. A good rule of thumb is to limit a single holding to 10-20% of your investible assets. Sometimes a concentrated position is unavoidable due to a company buyout or compensation paid in company stock. If you find yourself in this situation, you should consult with a financial professional to help you manage the risk and the potential tax implications of the concentrated position.

Inflation risk means that your purchasing power could be reduced by not keeping up with the pace of inflation. Historically, stocks have had the best hedge against inflation. Real estate investment, sometimes referred to as REITs, or Real Estate Investment Trusts, also offers some inflation protection because rental rates can rise over time, which can increase the total return. The main drawbacks to owning real estate are liquidity risk, meaning that is not always easy to sell it quickly, and capital requirements or minimum investment. Like stocks, you can purchase properties outright and own them or you can purchase them via private investments, similar to the way you would purchase mutual funds. By using some alternative investments in a portfolio, it is possible to lower the overall risk and produce a more consistent return.

I believe the correct amount of risk for my clients is the risk they are most comfortable taking combined with what allows them to meet their financial goals and objectives. Often people are unhappy with their current returns because of unclear expectations on either the risks or returns. Most people love the idea of achieving a high return with a low level of risk. That is just not reality.

Most people get frustrated and do not achieve the results they desire because they focus on the wrong number. Instead of looking at the overall return on an investment, we need to determine the amount of risk and return necessary to achieve their stated goals and objectives. To help our clients achieve the appropriate amount of risk, we lead our investors through a process that helps them determine their personal risk number in a range from 1 to 99. The higher the number, the more risk, or market fluctuation, a person could expect, but with the increased risk comes a potential for higher return (or loss). Once we have identified a client’s risk number, we customize a portfolio for them by comparing what they currently own to a plan tailored to their risk number. The portfolio risk number is obtained by adding the risk numbers of each holding in the portfolio based on its weighted average in the portfolio. Each risk number has a range expressed in both dollars and percentages that the portfolio is likely to trade within over the next 6 months. It is important to reassess your risk number periodically to make sure you are on track with your goals and objectives.

The average equity investor significantly underperforms in the overall portfolio because they make emotional decisions about when to get in or out of the market. Most people do not have an overarching investment strategy or the discipline to stick to that strategy. When emotions take over, the outcome often falls short of the intended results. But there is a better option: collaborate with a CFP® to create a personal investment plan, one designed around your risk and goals, then monitor that plan with your
advisor.

At Generations Financial Management, we believe that a personal risk number takes the guesswork out of the equations for our clients and sets clear expectations of their comfort level for risk. We begin by walking our clients through a risk questionnaire which allows them to choose between certain risk-and- reward scenarios. Once the survey is complete, it allows our client to confirm their risk number as well as an expected return. After determining a client’s personal risk number, we assign a risk number to their current portfolio to see how their current holdings align with their stated risk. If necessary, we revise a portfolio that matches their risk number. Most people find the personal risk number exercise to be worthwhile. It allows them to see both the expected upside and downside of a portfolio and helps set clear and mutual expectations.

What things are most important when it comes to assessing risk? Each person’s answer is as unique and different as they are. Because of this, it is important to work with a financial advisor who can help identify the amount of return you need to reach your goals and can identify different types of planning to help you get there. Once you know what you need to achieve, that can change your risk number over time.

For example, if you have many years in which to invest before needing access to the money, you may want to allocate more toward stocks. Stocks have higher risk than bonds and work better for a long range plan.

Talking with an advisor will help you understand the different types of investments, which ones may be more appropriate for you in the different seasons of your life, and how to blend these investments in such a way as to build a unique portfolio that meets your risk number. I encourage you to look for credentials such as a CFP® or CFA when performing your due diligence and deciding who to work with. You can verify an advisor’s credentials by visiting www.cfp.net or www.cfainstitute.org.