Our frequent readers know that we talk a lot about diversification and controlling your investment risk. That’s a great idea, but how do you define risk, and once defined, how do you design the best portfolio to meet your needs? By the end of this article you should have a pretty good idea.
When Janet Investor first met with her new Certified Financial Planner (CFP), she left impressed. It wasn’t that she left any wiser, but she knew her CFP sure could throw out a whole bunch of fancy technical terms.
Likewise, when you first enter the investment world, you will need to know a few terms and concepts to evaluate what your financial planner is telling you. Make no mistake, a good financial planner is worth their weight in gold. They can help you design a portfolio that is right for you. More importantly, when it seems the market has gone off the deep end, the same financial planner can keep you from turning paper losses into real losses through wise counsel.
So, what are the measures of risk used by investment professionals and what should you know about them. The following glossary should help you the next time you talk to your advisor. As you are reading through these definitions, bear in mind that the general rule “the higher the risk, the higher the possible return” is basically true.
Risks Applicable To All Types Of Investments
Market risk is the uncertainty caused by the potential that the value of investments in general will decline due to changes in the market caused by political, social and economic conditions.
Company risk is the potential that a particular company will not meet the earnings projections of analysts, be able to make regular interest or dividend payments or stay in business.
Inflationary risk is the possibility that the increase in the value of investments won’t keep pace with or outperform the general rate of inflation.
Reinvestment risk is the potential that an investor will not be able to reinvest the principal and/or interest in investments earning the same or better rate of return.
Industry risk is the possibility that the industry you invest in will fall out of favor or experience business difficulties and, as a result, the value of your investment will decrease.
Currency risk is the potential that your investment may decrease due to a change in the value of the dollar against foreign currencies.
Country risk is the uncertainty caused by changing conditions in countries where your investment is located due to social, economic or political difficulties.
Principal risk is the possibility that a particular investment will decrease in value.
Risks Affecting Mainly Fixed Income Investments
Credit risk is the risk that a company or governmental agency won’t be able to pay its debt on time.
Interest Rate risk is the potential that interest rates will rise and decrease the value of an investment.
Call risk is the possibility that falling interest rates will cause bond issuers to redeem (call) high yielding bonds.
Income risk is the possibility that dividends paid by a fixed income investment will decline as a result of declining interest rates.
ks Applicable To Mutual Fund Investments
Manager risk is the potential that the manager of an actively managed fund will fail to execute the fund’s investment policy appropriately and therefore fail to meet the fund objectives.
Now that we’ve given you a bunch of definitions we will try to help you understand how your advisors make sense of it all and apply it to you.
The first thing your advisor should do is sit down and ask you a ton of questions. Primary among them are questions to help determine your risk tolerance. Secondarily, your advisor should be concerned with your stage in life – just starting out, mid-career, near retirement, etc.
This barrage of questions is designed to find out where your are now, where you want to go and how to get you there while allowing you to sleep at night. In other words, the financial planner will help you take all of the risks previously defined and bundle them into a coherent strategy based on your preferences.
How do they do this? They use a number of statistical tools and software that track performance of various stocks and funds from their inception. The exercise will produce a mix of investments to help you invest along what is called the “efficient frontier.” In it’s simplest form, the efficient frontier is the mix of particular investments that best meet your return and risk requirements.
In more complicated terms, the efficient frontier is determined using two statistical measures. The first measure is rate of return. That’s a pretty simple concept, but the second measure – standard deviation – is a bit more complicated.
The standard deviation for an investment is how it compares to the average rate of return for all like investments (stocks, bonds, mutual funds, etc.). For example, say you are looking at a group of investments, the overall return on which is 20% over the last 20 years. If you have a stock which returned anywhere from 18% to 22%, its standard deviation would be 10% ((20%-18%)/20% or (22%-20%)/20%).
If you plot all the possible combinations of portfolios you can make with a group of investments with a 20% return and a 10% standard deviation, the result will be your efficient frontier. The theory is to design a portfolio that will help you meet your investment objectives while minimizing your risk.
Another benchmark your investment advisor will look at is the beta of a mutual fund. Beta measures the sensitivity of a fund to the markets movement. The market beta will always be 1.00. The beta of a particular stock or fund is the change in the investment’s performance as compared to the market as a whole. For example, if the investment you are looking at has a beta of 1.5 that means it has performed 50% better in up markets and 50% worse in down markets. A beta of .85 indicates the investment did 15% worse than the benchmark index in up markets and 15% better in down markets. The beta is useful in determining how much of an investments performance is due to market conditions as opposed to other factors.
The alpha factor used by financial planners is the measure of the investment’s actual return versus its expected return given it’s level of risk as measured by beta. If the alpha is positive, the fund has performed better than expected and if it is negative, is not true.
The alpha is used to determine how much value is added by the fund’s manager. In other words, it tells you whether the manager did better or worse than the market. This can help you decide whether you have enough confidence in the manager to give them your money to invest.
By putting all of the quantitative factors together with their knowledge of the intangibles (general national and international political and economic outlook) financial planners are able to craft a portfolio that will reflect your desires. Does this mean you will always make money in the market? No, but it does mean you will have the best possible chance of making money in the market based on your stated objectives. Sometimes the market doesn’t follow past trends. Given the returns we experienced in the 1990s, aren’t you glad the market didn’t follow its old patterns?
I hope this discussion has helped you understand how to look at risks in relation to your own portfolio. If you want further guidance, give us a call so we can discuss your individual situation.
Until next year, have a great holiday season and a prosperous new year!!!