Risky Business (or how to manage risk in your investment portfolio)

 One thing that the financial crisis of the past two years has taught us is the need to focus on risk as well as return.  However, it is true largely without exception that in order to make a return on your assets, you have to assume some degree of risk.

Even the safest forms of investment carry at least a modicum of risk.  For example, one of the least risky investments around is U.S. government debt (Treasury bills, notes and bonds of varying maturities).  And yet even short-term U.S. government debt carries the risk that the borrower will default and not repay the principal value on maturity.  Of course, the likelihood of the United States Treasury defaulting on its debt is small, but nonetheless it still exists and investors demand some premium as compensation for it.

At the other end of the risk spectrum lie investments such as derivatives, emerging markets equities, micro-cap equities and commodities.  The risks inherent in investing in any of these instruments are noticeably higher than that of buying a U.S. Treasury.  It is also true that because of this they would demand a higher reward, or expected return, for investing in them.  Coupled with this, investors in these instruments are also typically willing to accept a higher level of volatility in their returns than those buying low-risk products.

Somewhere in the middle you will find the types of investment products that the majority of individual investors are most familiar with and are likely focus on.  These include individual equity and corporate bond holdings as well as mutual funds.  Again, most savvy investors have a reasonably good idea of the level of risk they are taking on and the time horizon for investing in different asset classes.  But the experience of the past couple of years suggests that this may not be sufficient and perhaps something more is needed.

Below are some ideas for investors to consider in an effort to mitigate risk in their portfolios and maximize their expected returns:

1. Quantify the level of risk you are assuming
The first step toward mitigating risk is surely to better understand the level of risk that is being taken on in an investment portfolio.  For individual equities or bonds this may be a somewhat complex matter but for those investing in mutual funds it should hopefully be a little more straightforward.  Most investment managers will generally provide some sort of risk measure in their literature alongside details of historic returns.  This could be a volatility measure such as standard deviation, which assesses the level of volatility in returns around an annual average.  Or it could be a risk-adjusted measure, such as the Sharpe Ratio, which seeks to measure returns on a fund per unit of risk.  In any event, what is important is that whichever measure you use, there should be an element of consistency when comparing it across different funds otherwise it is fairly meaningless.  Of course, this is easier said than done as managers often choose their own risk measures rather than following a standardized path.  This is where a professional investment advisor could be of assistance in looking at all the different options with you.

2. Take a holistic view and invest over the cycle
Rather than looking at each individual asset and the risk and return on it, it makes more sense to look at your overall portfolio and the risk/reward characteristics that it carries.  In tandem with this, there is value in focusing on annualised returns across the cycle rather than on any one specific 3-month or 12-month period.  Both of these items are easy to say but harder to do.  Who hasn’t bemoaned the performance of their equity portfolio over a few months and then taken drastic action to correct it, only to then see the positions that they sold fly up in value?  The key is to stay the course unless you see a specific reason to do otherwise.

3. Diversify by asset class to smooth volatility
It has been proven time and again that one way to mitigate risk is to introduce diversification into a portfolio.  By holding only one asset class (e.g. equities or bonds), investors leave themselves exposed to volatility in that asset class.  Because assets tend to behave differently to each other at different points in the economic cycle, by combining two or more asset classes investors can smooth this volatility to some extent.  In determining your optimal asset allocation, it is important not only to consider the risk/reward profile of each asset, but also your own personal circumstances.  In other words, will you need to access the funds in a relatively short timeframe or are these assets that you are setting aside for retirement in 20 years time?  Depending upon your needs and objectives you may wish to allocate a greater portion of your investment portfolio toward a particular asset class.

4. Consider downside protection techniques
If you are investing in a risky asset class and you are concerned about the market outlook, it might be worth considering investing in some downside protection.  For example, if your asset allocation dictates 60% of the portfolio will be invested in equities but you are nervous about the near-term outlook for equities, you may wish to hedge against this and purchase put options on something like the S&P 500 Index.  This would provide some insurance against short-term market volatility and would help mitigate some of the risk.  Of course, the negative here is the cost (or premium) involved in buying the option.  Similarly if you were purchasing a foreign asset and were concerned about the currency exposure involved in doing so, you could hedge against this exposure for a fee.

5. Average-in your investment at times of market volatility
The final suggestion is a fairly simple one.  At times of market volatility, it makes a good deal of sense to average-in when making your initial investment or adding significant incremental amounts to it.  2010 so far has proven to be a classic example of why this makes sense.  The U.S. equity market has rallied at the time of writing by 12% from its low on 2nd February.  But prior to this it fell almost 10% from an earlier peak in mid-January.  In other words, so far in 2010 the equity market has been pretty volatile (albeit nothing near the volatility seen in 2008/09!).  While it is nice to think that you would make your investment on 2nd February, this dream scenario will most likely not occur.  To help mitigate some of this volatility, a sensible approach would be to tranche in your investment into the market, possibly investing 25% of your assets each quarter.  Of course, in doing this you run the risk of missing out on some upside potential.  But it also helps to limit downside risk to a certain degree.

So that wraps up a few simple ideas to help you identify the level of risk you are assuming in your investment strategy and manage that risk to some degree.  Of course, it goes without saying that consulting with an investment professional on these matters makes a good deal of sense before making any decisions.

Gareth Pulman is Senior Portfolio Manager with RBC Wealth Management.

The views expressed are the opinions of the writers and may differ from the views of Royal Bank of Canada or its affiliates.