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Understanding and Improving Your Risk Management Process

by Scott Smith

Risk Management ProcessRisk management shouldn’t be an afterthought in portfolio management. While talking about it with clients and formalizing a strategy isn’t as exciting as exploring growth potential, it’s one of those necessary conversations that advisors and clients need to have. Having a clear understanding of a client’s risk tolerance and how to manage it will make your relationship stronger and keep your sterling reputation intact. 

You can minimize risk by managing it with a broader perspective. Achieve improved risk-adjusted returns and drawdown mitigation by blending diversified alternatives into a traditional 60/40-split portfolio to outperform expectations over a longer timeframe.

Communicate with clients regarding risk limits

Define risk from a different perspective. Risk is not just a loss. It can be an insufficient gain as well. By thinking about risk this way as well, you can more precisely balance risk in your clients’ portfolios. Instead of talking about only gains and losses, discuss the possibility that some investments may not necessarily lose value, but won’t perform as expected either. Underperformance can be equally as detrimental to a portfolio as negative performance.

Evaluate performance in relative and absolute terms

When you first meet new clients, and again at annual meetings, you probably have the “risk” talk. Generally, the clients decide how much risk they can tolerate and assume. You and the client agree on objective, absolute benchmarks against which to measure an investment for both risk and performance. In most cases, this means no loss of principal value. However, even this seemingly-straightforward definition has relative, flexible parameters.

Consider the following example:

From January to June, a stock increased in value by 10%. A significant gain and a successful investment by all measures. But from July to December, this same stock lost 9% of its value. Over the one-year time frame, the gain is really only .1%. 

Depending upon how you look at this, and the time frame in which you are evaluating its performance, it’s either a big winner, or a very-small winner. It didn’t lose its principal value but it didn’t perform over a one-year period as well as it did over a six-month period. Set the parameters up front with the client about how you will evaluate asset performance relative to other factors, like time. 

Consider the absolute, raw numbersthey either go up, down or stay the same. In a vacuum, they are somewhat meaningless. By evaluating these numbers within an agreed-upon time frame, the numbers have meaning and purpose. That being said, you can better determine gain or loss and estimate risk. 

Look beyond historical data at trends

Historical data is just that, static numbers that aren’t up for debate. This data already reflects the economic, political and social events that perhaps affected performance during the period in which the measurements were taken. It’s almost too easy to rely on the certainty provided by these figures when trying to understand what will happen in the future. 

But, just as current events affected the historical values, now set in stone, current events will continue to affect performance going forward. Therefore, you must continue to consider them when evaluating potential risk and exposure. For example: 

  • Research whether there are any pending interest rate adjustments. 
  • Consider which other economic factors this investment may be sensitive to. 
  • How much does the investment’s value correlate with the changes in the equity markets or the credit markets? 
  • Determine whether the percentage correlation is too high or too low. 
  • Which market could potentially affect the portfolio more? 
  • Bond values are inversely related to interest rates, but to what degree will this affect alternative investments? 

Balance and minimize risk by blending in alternatives

Consider including another source of equity returns, alternative investments. Alternatives can improve portfolio performance in this post-financial crisis environment. It’s become more advantageous to have alternatives provide differentiation and independence from market swings and other political and economic factors. By diversifying the traditional 60/40 portfolio a bit, and investing more in both conservative alternatives and aggressive alternatives and less in stocks and bonds, you can minimize risk, including the risk of underperformance. Interestingly, a simple 60/40 ratio may be less safe and riskier than diversifying with appropriately vetted alternatives. 

Some alternatives can improve returns while keeping risk factors the same as investing in stocks. Other alternative investments are less risky, like bonds. However, both sorts serve the same purpose in portfolios as stocks and bonds. 

Recently, alternative investments have outperformed equities. We’ve seen better returns with less risk over the long-term. This helps improve risk-adjusted returns and mitigates the chance of drawdown over a longer period. It is time to reevaluate your risk management strategies and consider including alternative investments.

Investor expectations should drive your risk management processes

In the past, the goal was to invest securely, conservatively and in stable markets that provided little growth. Investors are now more than ready to look beyond this standard, vanilla formula and micro-diversify within their portfolios. The ratio itself is not the issue, it is the makeup within each portion that we recommend shaking up a bit to include alternatives that will either increase returns or balance market risk. Micro-diversifying within each asset class using alternative types of investment products may produce a more stable, reliable portfolio. 

While the old paradigm worked well after the crash, investors are getting anxious for better returns without taking on more risk. The new way to meet demand is to diversify into alternatives that provide better returns from both aggressive and conservative products. Investors, frustrated with slow or no growth, are ready to move on to including alternative products in their portfolios. They are willing to consider alternative products and have no qualms about abandoning the status quo formulas or advisors who won’t consider offering vetted alternative investments.

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Filed Under: Due Diligence