Key Perspectives On Risk | Essential Discussions with clients
By: Christophe Voegeli
Risk. A scary word to people, no matter the context. Whether hiking a mountain, leaving an employer, or investing a dollar, risk is something we are evolutionarily predisposed to avoid. But in the world of money, when risk is mentioned, what exactly is being said? In an earlier article on financial mathematics (fall 2013 issue of the Exempt Edge), there was a focus on the various sorts of rates of returns. When returns are considered, so is risk, but what is risk? Much like rates of returns, there are several variations. These include loss of principal, time frame risk, liquidity risk, market risk, firm risk, and regulatory risk, and how these impact the investments clients hold.
LOSS OF PRINCIPAL
One of the simplest concepts clients and Dealing Representatives (DRs), understand is risk to capital; it means the client has lost money. Commonly, investments are discussed in relation to the security, or safety, that is being offered. In other cases, it is very clear there is risk to the invested capital. Security could be a function of government regulation, like some bank and insurance products that have potential guarantees. Alternatively, security could be a matter of underlying assets, with no guarantee, with the security only contingent on the value extracted from those assets and their management. Principal security is usually a function of the nature of the investment, its management style, and most significantly, the asset class and the regulatory channel in which it finds itself in.
With equities and real estate being the most common and significant assets carrying risk to most investors, how can one protect themselves from loss of principal? For real estate, it is often said that you do not make your money when you sell, but rather when you buy. The notion here is that buying an asset ‘on the cheap’ will help to protect your principal. With equities, the same theme applies. When buying stocks, it is prudent to purchase them with a margin of safety, a term coined by the famous Benjamin Graham. With both these asset classes, trying to compute what is ‘cheap’ is a far from perfect game of assessing valuation metrics, reviewing historical data, and making projections. While individual securities can always lose, buying an asset for the long term may help avoid a loss to principal, as long as the asset recovers over time.
Time frame risk: “In the long run, we are all dead”
Economists (including Keynes who is quoted above) have a propensity to observe trends in both the short and long term. The theme of such a tagline is suited for the exempt world, as often assets are illiquid and medium to long term in nature. Exempt investments loosely refer to alternative assets, which are different from most retail investments such as mutual funds and stocks. While the above paragraph noted holding onto assets for the long term can be a good approach, time frames are always a consideration, and there may be risk. This is called time frame risk; the risk that someone cannot ‘wait’ for the investment to exit or redeem. Land and real estate developments are the best examples of this.
Liquidity risk: “Fundamentals hurt, weak balance sheets maim, but liquidity kills”
Time frame risk is also tied to liquidity risk; the notion that an investment cannot be sold, even if an investor needs the cash. At the peak of the banking crisis, the above quote by analyst Chris Taggert was popular. Cash is king and when cash is needed investors do not care about upside or exciting projections; they just want to sell. An emergency fund is a good text book example where most investors need safe, liquid, and low tax consequence money. Three to six months of fixed basic living expenses is suggested, and liquidity is critical; in this case, any exempt investment is ill advised.
Excess Returns: Always a good thing, if you don’t count risk
While a lot of financial models and academic research suggest investors are rewarded with excess returns when using long term and illiquid assets (a strong argument for using exempt assets), investors and DRs should be aware of specific liquidity needs and time frames in the investor’s life cycle. This is core to the planning process and should never be undermined. This being said, there is often a misconception that long term assets with risk are not suitable for a retiree. While having ample liquidity and some guaranteed income with security are paramount (often called an income floor in retirement planning), inflation and exhaustion of capital (called longevity risk) are serious risks too. For a couple at 65 years old, who will very likely see at least one of them live to their mid 80s, there is still a place for long term assets, as their portfolio still has a long term element. As long as the retired investor can absorb the investment, time frame, and liquidity risk, there can be a place for risky assets, with allocation and exposure remaining major considerations. If the investor cannot absorb a loss, stick to guaranteed tools mostly or entirely. This distinction is most critical for retirees. A very common allocation rule of thumb is to make the investor’s age the percentage of their portfolio which should be in safe or guaranteed investments. This is a guideline, but a prudent and sound one indeed.
MARKET RISK OR FIRM RISK
Financiers often seek out the composition of risk. Total risk of an individual stock is made up of (1) market based (systematic risk) and (2) firm specific (idiosyncratic risk). For example, a stock investor that diversifies their holdings across 100 stocks across the whole market will have a portfolio that mainly consists of market-based risk, with the investor’s portfolio sensitive mainly to broad market movements. Alternatively, with firm specific risk, an investor that buys just one stock has all risk concentrated into the performance of that single company.
Interestingly, research shows that if one large company stock is purchased in each sector of the economy (financials, energy, healthcare etc), total risk stems mainly from market-based risk; that is, firm specific-risk is virtually eliminated by investing in just 10 to 14 stocks. In other words, an equal investment in each of a dozen stocks is all it takes to achieve a well diversified portfolio.
Over the last decade, equities have nearly been flat on many nations’ stock markets, yet all the while with significant swings in value; a cork in the ocean, some might say. While the last 10 years have been a rough economic bout, the loss of principal, in the case of a flat but volatile stock market, is purely a matter of when (and what) the investor bought and sold. In the world of public finance and related academia it is often said that picking stocks or timing the market is (near) impossible, and picking currencies is even harder.
The challenge, and opportunity, of the exempt space is that an investor is picking a management team, in contrast to a broad asset class or currency, for example. Returns are less about selecting assets based on valuation methods and public data (like the stock market), and more about selecting a specific asset, a business model, and a team leading the use of funds. That is, in the exempt world risk and return are often more about firm specific risk than market based risk. As a result, the risks and return outcomes of the exempt space can be very different than that of a public security. The hopeful side effect of this of course is that a return can be had on your money, which is tied to both management skill and asset performance, and less so on the public news and factors that can affect the stock market. However, there are always factors that can affect both public and private markets, never mind a specific investment.
KEY MAN RISK
In the exempt world, reporting, monitoring and regulation are very different from the public space. Key man risks become far more severe. This can include management risk, misappropriation of funds, and simply put, ‘people not doing what they said they were going to do.’ These risks do exist in the public space, but with the public eye and robust reporting required, these risks are managed in a very different way.
Efforts are being made by the regulators, dealers, or the industry as a whole through NEMA, to strengthen the exempt space. However, this regulation also has a cost, which is why the people behind issuing companies do seek out the often cheaper and more limber exempt space, which may allow returns to be had for the exempt investor. Yes, the exempt space carries opportunity, but risks still present themselves, and clients must always be made aware.
While DR and client meetings can be filled with planning concepts, tax talk, and discussion of beneficiaries, the word risk comes up more than anything. This is due to the regulatory environment indeed, but at a higher level it is for the client’s best interest. Explaining risk to a client in a language they can understand is key, as it protects the DR, the dealership, and most of all, the client.