Risky business - managing risk within your portfolio
If there is one thing the last couple of years has gotten us talking about - its risk. Whether we’ve been evaluating the risk of taking an international flight, or trying to estimate how long supply chains will be constrained and its impact - risk has taken on a whole new dimension in our worlds.
When markets are uncertain, the appetite for risk typically decreases - it’s much easier to stomache the idea of volatility when everyone is making money. With that, its natural for dips in the market to have investors evaluating if they have the same tolerance for risk as they initially thought. In some cases, people will say “I want no risk at all, what do I need to do?”
To that I say, it is a sisyphean task to try to eliminate all risk from a portfolio, and frankly, it’s not worth trying to. You might say “that’s crazy, I’m always told GICs are zero risk” and while they are not exposed to market risk, they still have other risks that may not be desirable. In any given portfolio there will always be some element of risk, it is just a matter of determining what kind of risk, and at what level, is acceptable to us.
A Brief Summary of Types of Risk
In day to day vernacular, risk has a negative connotation - people engaging in risky activities such as skydiving, etc. For the purposes of portfolio management, risk is not inherently good or bad. Risk, broadly speaking, is an exposure to uncertainty. Sometimes this uncertainty will work in your favour, but that isn’t a guarantee - and is the tradeoff investors make to increase their expected returns. There are many types of uncertainties (or risk) that could be present within a portfolio. Some things are going to be on the minds of all market participants, such as:
Market Risk. This is the one that most people think of when you consider risk in investing. It is the risk that arises from fundamental economic conditions, events in the economy or specific industries, or developments from specific companies. Market risk can be further divided into two main types:
Systematic risk - risk that cannot be avoided and is inherent in the overall market. It is non-diversifiable because it includes risk factors that are innate within the market and affect it as a whole, and includes things like recessions, impact from interest rates, natural disasters etc.
Non-systematic risk - risk that is local to a particular asset class or industry that need not affect assets outside that class. This includes things like changes in technology, resource discoveries, failed drug trials, or changing consumption patterns. This can be mitigated via portfolio diversification.
Credit Risk / Default Risk is the risk of loss if one party fails to pay an amount owed on obligation, such as a loan, bond or derivative to another party. Essentially, if someone is lent money, how likely are they to pay it back? Credit ratings agencies provide an insight into how willing and able various entities are likely to be in repaying their obligations.
Liquidity Risk is about accessibility. If you are invested in an asset or fund and need to get out of the position, how quickly can you do it? Will you suffer significant downward price pressure to do so? This is a larger risk with private investment, or for individuals who hold real estate properties as a large portion of their wealth.
Inflationary Risk is the risk that inflation will reduce the real growth of your assets. In a healthy market, a degree of inflation is expected - in Canada 2% inflation is the targeted rate. Most financial planners will account for a degree of inflation when mapping out a plan and making investment decisions. The risk comes when inflation is higher than expected, or if you choose to exit the markets entirely (or move into instruments that offer a return below the rate of inflation), and your funds lose real purchasing power over the long term. This is the principle concern with extremely safe, low volatility investing, such as GICs.
Currency Risk occurs when you are investing in another currency than what use to live on. If you are living in Canada and investing in the US market in US dollars, you need to consider both the absolute return of your investment, and the change in the value of the US dollar relative to the Canadian dollar. Many funds offer an option to accept this currency risk, or to have the currency component hedged out.
Interest Rate Risk is the risk of a decline in an assets price due to an unexpected interest rate fluctuation. This is more common in fixed income instruments whose prices are largely dictated by interest rates, particularly if you do not plan to hold the bonds to maturity.
Compliance Risk includes regulatory, accounting, and tax risk. The rapid development of leading edge industries tend to move faster than government regulation. While this can provide an opportunity for significant growth, once the regulatory bodies catch up, laws and policies enacted can have a material impact on the value of the strategies employed by a company or an individual. A current example would be the scrutiny governments are giving to the cryptocurrency market as they struggle to determine how to regulate this industry.
As an investor, you may not be worried about Model (or Tail) Risk but Portfolio Managers or Fund Managers will be. This is the risk of incorrect assumptions in a model or the use on an inappropriate model when predicting outcomes (tail risk is specifically not accounting for the biggest moves as often as they wind up occuring). While most retail investors are not utilizing modelling in their investment decision making, this is relevant particularly when fund managers (particularly for actively managed funds) are determining their investing strategies for the funds that end clients are participating in.
And of course, since you are most concerned with your investments aligning to your financial plan, here are some things to discuss with your Financial Planner that may not be addressed from a Fund Manager level:
Concentration risk, particularly if you have an employer share ownership plan. If you are working in a particular industry and you have investment holdings in that industry a downturn could negatively impact your employment prospects as well as your portfolio. You should discuss with your Financial Planner whether any steps need to be taken to adjust your remaining portfolio to balance that concentration or whether a sales strategy can be implemented to reduce the concentration.
Mortality risk, what happens if you die sooner than expected? Many of us have a plan for what we would like to see happen after we pass, but this tends to assume assets worth a certain amount. If something happens early, will your plan still work? If not, this is where insurance will work as a risk transferrence strategy - essentially you pay a company to take this risk off your hands and if you die early an amount will be paid to your beneficiary or estate to make sure your goals are made.
Longevity risk, the flip side of mortality risk - what happens if you live longer than expected? If your plan is to spend all your wealth in your lifetime, obviously living longer than expected presents some risks. Even if you do plan to leave assets to heirs or charities, living longer than average may impact these goals. If you are concerned about your ability to maintain your plan if you live longer than anticipated, looking at an option like a lifetime annuity (which works like a defined benefit pension) may be worthwhile.
Morbidity risk is similar, but looks at what happens if you become ill before you have met your financial goals. If you are forced to stop working, you may no longer be able to contribute to your portfolio, or if you require in home care your cash flow needs may change dramatically. If you are in a position where you no longer need to work, and have the assets available to pay for unexpected treatment this may be a risk you are comfortable retaining, but if not you should consider Disability or Critical Illness Insurance.
Effective portfolio management isn’t about removing risk from a portfolio, it is about implementing risk management. This requires understanding the risks that best balance achieving your goals with the acceptable and quantified risk of failure, and continuing to monitor it. As you can see from the above examples, often times these various elements of risk work in contrast to one another - seeking excess returns will minimize inflationary risk but increase market risk. Investing in certain types of bonds can decrease market risk but increase interest rate risk.
Which risks are acceptable to you, and at what level are not necessarily going to remain constant either - during uncertain periods an investor may be comfortable with inflation risk over the short term to ensure they are less exposed to market risk. If you have a long time horizon you may be willing to accept liquidity risk if you think excess expected returns are available. While
some risks (like systematic market risk) are unavoidable if you participate in financial markets, some risks may be mitigated through various strategies, such as adequate diversification. hedging, or insurance.
Ultimately, an important part of portfolio construction is an in-depth conversation about the various risk factors that exist in the market as a whole and to you as an individual and determine which elements of risk are acceptable in a portfolio, which are not, and for what time period. And of course, this conversation will change through time so it’s one that should be had early and often with your financial planner (if you are looking to get started, I can be reached here for an initial consultation).
Elyce Harris is a CFA Charterholder working with Cornerstone Investment Counsel, a registered ICPM in Alberta, Canada. She is also a licensed insurance broker in Alberta, Ontario, and PEI. While every effort is made to ensure the accuracy of statements, errors may occur. If a specific stat or carrier policy is cited, a source will be provided, however this is not done for generalizations.