Recently, the severe bear market correction reminded us that successful investing is not about taking undue risks, such as chasing hot stocks or putting all your savings in GM bonds. Investors need to understand (1) their tolerance for risk; and (2) the risks present in their investment portfolios. To be a good investor, you need to be a good risk manager.
In the investment world, risk is typically measured by price volatility. You may have heard the word “standard deviation” thrown around as a measure of portfolio risk. It means how much the value of an investment moves up or down. The more a portfolio goes up or down, the higher the “risk” of the portfolio. Focusing solely on price volatility to manage risk can lead to poor investment results. It’s only one piece of the puzzle.
The process for managing all of the elements of portfolio risk is called “Risk budgeting.” It involves assessing an investor’s appetite for risk and seeking to quantify how much risk – beyond traditional price volatility – an investor is willing to assume. Risk budgeting includes controlling exposure to such risk characteristics as:
- Leverage: Is leverage built into a portfolio? The more leverage, the more risk.
- Concentration: Does the portfolio have a large, concentrated position? A bond portfolio that has a large concentration in Treasuries right now would be a cause for concern given the strong run up in Treasury notes and bonds.
- Event risk: Is the portfolio over-exposed to any single market event? If the portfolio is primarily a high-dividend portfolio, it could be heavily weighted in financial stocks, and thus, over-exposed towards a credit crisis, such as the one we saw late last year.
- Liquidity: Is it easy to sell the securities in the portfolio quickly? Not enough liquidity can cause a cash crunch.
- Transparency: Do you know what is going on with your investments? Can you see what your portfolio manager is doing? Bernie Madoff’s investment process lacked transparency – no one really knew how his investment process made money.
Portfolio returns come at a price – and that price is the assumption of risk. If we knowingly assume high risk, we should expect high-return potential. If we take on low risk, we should expect low-return potential.
John Weitzer, CFA, is senior vice president, senior investment manager for Wells Fargo Private Bank in Milwaukee.