Looking at risk from the good side

“It is hard for clients,” Smith says, “to understand the different types of risk.”

But if your clients understand the investment risks they are taking to achieve their goals, they will be less inclined to worry about their choices and thus decide to remain invested for the long term.

This would also make it easier for you to explain gaps that could arise between your clients’ expectations of how their portfolios should perform and the actual performance of their investments during volatile market conditions.

“Risk becomes a problem only when it is unintended, misunderstood or uncompensated,” says Wylie Tollette, senior vice president of investment risk and performance with Franklin Templeton Resources Inc. in San Mateo, Calif.

Tollette recommends that you intentionally take risks that you and your clients fully understand and for which your clients are compensated.

For example, Tollette explains that you might recommend that your client invest in an Australia-based mining company, based on your positive outlook for the sector and the Australian economy. However, you may discover that the performance of this company is highly correlated to that of a China-based company – in which case, the risk you are taking becomes unintentional.

You should take a holistic approach based on your client’s financial plans, suggests Gaétan Ruest, assistant vice president, product and corporate research, with Investors Group Inc. in Winnipeg.

Ruest says the underlying question that must be answered is: “What are the risks of your clients not achieving their financial objectives?”

In responding to this question, Ruest says, you must be able to determine why your clients have a certain level of risk tolerance.

Market risk is the primary risk to which your clients are exposed. And although this risk typically is associated with variability in stock prices, it has several components including equity, inflation, currency, interest rate, credit, liquidity, counterparty and capitalization risks.

Equity, inflation, currency, credit and interest rate risks are associated with the possibility of change in the investment value over time.

For example, equity prices will vary, credit quality may decline and foreign exchange, inflation or interest rates will change, thereby affecting the value or performance of your clients’ investment portfolios.

The impact of each of these risks, says Smith, depends on the exposure your clients’ portfolio has to them.

Capitalization risk is tied to the size of the investee company.

“Large companies tend to be less risky and less volatile,” Ruest says. “Small companies may outperform because they have more growth potential.”

However, Smith cautions, small companies can be less liquid, which introduces liquidity risk into the portfolio.

@page_break@ On the other hand, counterparty risk is an embedded risk. It refers to either party of a contract failing to live up to its contractual obligations; it can be a type of credit risk that is related to a borrower or a bond issuer that defaults on its debt obligations; or it can be associated with derivative transactions in which, for instance, the writer of an options contract does not buy or sell the underlying asset as agreed.

You do not want your clients to participate in transactions with high counterparty risks, notes Tollette, as “you do not get paid extra for doing business with a risky company.”

In order to reduce your clients’ risk exposure, Smith recommends that you work with your clients to diversify their portfolios across asset classes that are not perfectly correlated.

In doing so, you will have to make extrapolations from past performance. However, Smith recommends that your clients be encouraged to take a cautious view in this regard, primarily because the performance history of an investment is not a reliable indicator of its future performance.

You would be well advised to stress-test each client’s portfolio, a strategy that is much more useful than forecasting, Smith says. Stress-testing a portfolio involves the use of simulation models to determine the future performance of the portfolio under various market conditions.

A well-diversified portfolio, Tollette says, also looks at risk “from a risk-factor diversification standpoint.”

Ruest argues that all risks are “diversifiable” – meaning that the risks can be reduced by diversifying the investments in the portfolio. Although this is theoretically true, some risks – systemic risks, for example – that relate to events that can affect the global economy typically are not diversifiable.

A well-diversified portfolio takes into account that the performance of different asset classes varies over time, says Smith. This implies, he says, that all asset classes in a portfolio in a given period of time might not necessarily be performing well.

Given this performance variability, you should emphasize to your clients that a portfolio typically is constructed for long-term investing and that the asset classes that are not performing well eventually will recover.

One of the more contentious issues when discussing risk is volatility, which investors typically associate with risk.

“Volatility of an investment is not a risk,” Ruest says, adding that it is directly related to a client’s ability to tolerate variability in the value of the investments.

Tollette recommends that your clients “use volatility to their advantage, versus panicking in the face of it. Those who don’t panic are the most successful.”

Adds Smith: “Volatility must be consistent with clients’ expectations of variability in returns.”IE

In the March issue: Explaining the role of diversification and asset mix in reducing your clients’ investment risk.

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