Perspectives on Wealth

Understanding and Managing Financial Risk

Part 2

October 5, 2011 — We have experienced extreme volatility in the markets recently. The Dow Jones Industrial Average went down 635 points on August 8, up 430 the next day, down another 520 the next, and up again on August 11 by 423 points.ⁱ It’s no surprise that investors are concerned or even frightened.

Most people want to put away and keep a nest egg for their retirement, their children’s education, or a legacy for their heirs. And, it’s difficult when our hard earned savings are threatened. So, what should be done? I discussed Inflation Risk, Currency Risk, Interest Rate Risk, and Systematic and Unsystematic Market Risk, and noted in Part 1, that financial risk exists all the time and affects everyone. Even if we choose to do nothing, we are still subject and exposed to some type of risk. Financial risk is unavoidable, and that is why the best course of action is to attempt to manage it, not ignore it. Here in Part 2, I will discuss what you can do to manage these risks. I have been managing investments and my clients’ wealth since 1997, and below I will tell you what I am currently doing at this time with my clients’ portfolios.ⁱⁱ

Modern Portfolio Theory - It’s very important to first mention that I utilize the principals of the “Modern Portfolio Theory”ⁱⁱⁱ to develop diversified portfolios over a variety of asset classes.^iv The gist of MPT is that the market is hard to beat and that the people who beat the market in the short term are those who may take above-average risk. It is also implied that these risk takers may take significant losses when markets turn down. Why do I take this approach? Because by participating in more than one investment, one can reap the benefits of diversification, which results in a reduction in “Unsystematic Risk”, a type of Market Risk discussed in Part 1. Also, by investing across a variety of asset classes, one will reduce “Systematic Risk”, another type of Market Risk previously discussed. However, the benefits of these risk reductions will hold only if the securities in the portfolio are not perfectly correlated. In other words, they do not move in unison together. Consider a portfolio that holds two securities: one that pays off when it rains and another that pays off when it doesn’t rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. Adding one asset to another can reduce the overall risk of an all-weather portfolio. That is the underpinning basis of the Modern Portfolio Theory that I utilize.

Ask “What is my Tolerance for Risk?” - So what is the first step? I first start with a discussion as to what is the appropriate level of risk for each client. What are their goals and objectives? What is their time horizon? Some people are more aggressive than others. However, many of my clients are conservative and satisfied with earning a more modest return with a lower amount of risk.

What is the Appropriate Investment Model? – Based upon my client’s goals and objectives and the client’s tolerance for risk, I recommend an appropriate customized investment model. The model always contains a variety of investments and asset classes to reduce both Systematic & Unsystematic Risk, but could be weighted in favor of more conservative assets such as cash & bonds versus stocks. For example, a very conservative client may select a portfolio consisting of 80% cash & bonds and 20% equities.

What Investments are in the Current Models? – I periodically review and update my models as market conditions change and develop. Right now, my investment models contain the following traditional asset classes to varying degrees with a current emphasis on the following:
 

Cash & Bonds – Because of current concerns regarding Interest Rate Risk, my current models primarily include short term investment grade and floating rate US bonds. US Treasury Notes and long-term bonds are not preferred. Foreign source bonds also hedge against Currency Risk concerns. Cash positions hedge against Market Risk volatility.

Large Cap Equities – What is most compelling about today’s market is that valuations of many corporations in the S&P 500 Index trade at forward PE ratios of less than 10.^v That means that stock prices have to rise or the earnings estimates have to fall significantly for these stocks to return to their normal valuations. Dividend yields of many corporations in the S&P 500 and the Dow Jones Industrial Average are extremely attractive when compared to the 10-year U.S. Treasury yield, making dividend paying Large Cap Equities attractive at this time.
 

International Equities – Foreign source dividend paying equities provide necessary diversification to the US securities market as required under the Modern Portfolio Theory, and also hedge against US Currency Risk concerns.

Alternatives – This asset class primarily provides securities which are not highly correlated to other positions in the portfolio which decrease the overall risk of the portfolio.

Summary

Just by living in society, we are all exposed to many types of financial risk. There are some things that we can control, and others that we cannot. Understanding the financial risks that exist and doing our best to manage those risks is our best course of action. It is suggest that investors should employ a globally diversified portfolio with exposure to fixed income, equities, and real assets, in accordance with their risk tolerance levels and investment objectives.ⁱⁱⁱ With equity prices on a roller coaster ride lately, it reminds us how critical it is to have a balanced approach to investing. Putting all your “eggs in one basket”, such as a few stocks, or a large CD, is not the answer. These won’t protect you from all the financial risks that are out there, such as Inflation Risk and Currency Risk.

If you have questions, I would be pleased to discuss these issues with you in greater detail. Please feel free to give me a call at 508-478-2600 or 800-648-1000.

Wayne R. Davies, CFP, ChFC September 27, 2011

SOURCES