Unmanaged Risk is a 4 letter word
By: Cora Pettipas
There have been considerable discussions in the Exempt Market Industry and with Regulators lately regarding risk. Proper risk assessment and risk taking is as vital in investing, as it is in life. In the Exempt Market, specific attention and care need to be given to liquidity risk.
When having conversations with clients, risk is the four letter word that should be discussed simultaneously with investment return. How should risk, more specifically liquidity risk, be approached with clients? Here are five suggestions for better risk discussions with investors in the Exempt Market.
1) Identify the Risks
The first step to an effective investment risk management process is identifying the risks, and communicating them with clients. Some of the most common investment risks are: business risk, market risk, interest rate risk, inflation risk, marketability risk, liquidity risk, political risk, exchange rate risk and credit risk. As every advisor knows well through experience, specific risks differ for different investments. Even though Exempt Market products are by no means homogenous; liquidity, marketability, and business risk are arguably the biggest threats to exempt market products. Luckily, business risk can be significantly reduced through diversification. Liquidity and marketability risk can be managed, but not eliminated, in the exempt market. Illiquidity can be an advantage if investors are looking to hold assets longer term and do not want to be influenced by public stock market mood swings.
2) Know how the business model may interact with the market
Exempt market offerings in Canada tend to be localized and tangible. Whether investing in mining or real estate, it is important for an advisor (and investor) to have a basic sense of the microeconomic forces and macroeconomic cycle that can affect market conditions. Especially in an age with increased tampering of fiscal economic policies, seemingly innocuous factors like mortgage legislation, tax policy, trade flows and austerity measures can highly impact companies. This is not to say the future can be predicted, as it cannot be consistently. It just means that the advisor can give background information as to why they are recommending certain strategies.
3) Make Sure the Investor has a Solid Financial Base
Before investing in exempt market securities, or any securities for that matter, a client should have a solid financial base in place, with positive cash flow, liquid assets and an emergency fund of at least six months expenses. A lot of investors will consider their home equity line of credit an adequate emergency fund. It is not. Anyone working in financial planning or an advisory capacity to investors will be amazed at how people’s lives and occupations change so drastically in short periods. Marriage, divorce, illness, job loss, children, and starting a business, and an unlimited array of other scenarios, can all alter someone’s financial trajectory. The fact that anything is possible makes life fun, but clients cannot run to cash in illiquid assets to cover the change in life circumstances.
4) Lengthen The Time Horizon
In our society we tend to sometimes indulge in instant gratification. Selling, switching, and changing investments on a whim can be satisfying. It can also be detrimental when an investor’s assets are sold for funding lifestyle expenses that were not part of the financial goals. It comes at a long term cost of their financial goals, future, and legacies. The timelines of these investments need to match the client’s timelines for use, plus a buffer of time for illiquid assets, while still having flexibility in the plan for life changes. Most Canadian investors understand illiquid products intuitively, as they have been investing in GICs for years. Up until a few years ago, the most popular GIC was the 5 year fixed. Therefore, having investments that are illiquid instead of marketable can be advantageous, if the proper diversification is in place.
5) Diversify & Rebalance
Diversification gets a lot of attention, but it is not always enacted in investors’ portfolios. Some of the factors that push investors into specialization, as opposed to diversification, are: a concentration of knowledge in one area, employer stock option plans, unbounded exuberance about a certain sector or company, and policy legislation. A popular rule of thumb is an absolute maximum of ten percent of your portfolio in one security. Like gardening, after setting up the perfect diversified portfolio, the portfolio will need maintenance. Rebalancing is hard for investors, as it takes a contrarian edge to sell the best performing ones and reinvest in underperforming asset classes, but it is empirically proven to help returns.
In short, risk cannot be avoided in investments, or in life. Unlike other areas of life, risk in a financial portfolio can be successfully managed. Most of all, advisors not only need to discuss risk with exempt market investors, but have the clients understand it enough that they can explain it back to the advisor. Even though risk is a four letter word, risk should be mentioned in every client conversation. Properly managed, the illiquid risk of exempt products can actually solidify a portfolio.