What is Risk Management?
Since every investment involves taking risk, in managing your wealth we must consider how to manage and mitigate the risks associated with investing. In fact, managing investment risk is equally, if not more important, than building and managing an investment portfolio.
What are the essential risks of investing?
For every investor, investment risk is the possibility that they will lose money or not make money on an investment. Investment professionals usually define investment risk as volatility of an investment’s return over time around its average return, as measured using standard deviation. A risk free investment is thought to be the three month U.S.Treasury bill.
Loss only occurs when the investor sells when the market is down or the investment value is below its cost. However, over the long term, since 1929, the market has been up 7 out of every 10 years. So why do investors lose money in the market? We would submit that one of the main reasons is that investors fail to understand the risks associated with investing.
There are multiple types of risk every investor faces:
- Interest-Rate Risk
Fluctuations in interest rates may cause investment prices to fluctuate. For example, when interest rates rise, yields on existing bonds become less attractive, causing their market values to decline.
- Market Risk
The price of a stock, bond, mutual fund or other security may drop in reaction to tangible and intangible events and conditions. This type of risk is caused by external factors independent of a security’s particular underlying fundamentals.
- Inflation Risk
When any type of inflation is present, a dollar today will not buy as much as a dollar next year, because purchasing power is eroding at the rate of inflation. This is also known as purchasing power risk.
- Currency Risk
Overseas investments are subject to fluctuations in the value of the dollar against the currency of the country where the investment originated. This is also referred to as exchange rate risk. However, investors in U.S. companies are also subject to currency risk since 45-50% of the S&P’s profits come from overseas operations.
- Political and Legislative Risks
Companies face a complex set of laws and circumstances in each country in which they operate. The political and legal environment can change rapidly and without warning and with significant impact on financial markets and securities. This is especially true for companies operating outside of the United States or that conduct a portion of their business outside of the United States.
- Reinvestment Risk
This is the risk that future proceeds from investments may have to be reinvested at a potentially lower rate of return (i.e. interest rate). This primarily relates to fixed income securities.
- Business Risk
These risks are associated with a particular industry or a particular company within an industry. Generally, business risk is that a company will go bankrupt or perform below expectations. Every company carries the business risk that it will produce insufficient cash flow in order to maintain operations. Business risk can come from a variety of sources, some systemic and others unsystemic. That is, every company has the business risk that the broader economy will perform poorly and therefore that sales will be poor, and also the risk that the market simply will not like its products.
- Liquidity Risk
Liquidity is the ability to readily convert an investment into cash. Generally, assets are more liquid if there is an active market for the asset. For example, Treasury Bills are highly liquid, while real estate properties are not. Investors holding emerging markets or micro-cap funds are subject to liquidity risk.
- Financial Risk
Excessive borrowing to finance a business’ operations increases the risk of profitability, because the company must meet the terms of its obligations in good times and bad. During periods of financial stress, the inability to meet loan obligations may result in bankruptcy and/or a declining market value. Financial risk is perhaps the greatest risk faced by high yield bond investors holding bonds rated below B.
- Foreign Investment Risk
Investments in foreign securities may be riskier than U.S. investments because of factors such as unstable international, political and economic conditions, currency fluctuations, foreign controls on investment and currency exchange, foreign governmental control of some issuers, potential confiscatory taxation or nationalization of companies by foreign governments, withholding taxes, a lack of adequate company information, less liquid and more volatile exchanges and/or markets, ineffective or detrimental government regulation, varying accounting standards, political or economic factors that may severely limit business activities, and legal systems or market practices that may permit inequitable treatment of minority and/or non-domestic investors. Investments in emerging markets may involve these and other significant risks such as less mature economic structures and less developed and more thinly-traded securities markets.
- Actuarial Risk
This type of risk is covered in exchange for premiums by an insurance underwriter. It takes two forms: 1) the risk of premature death, and 2) the risk of outliving your assets. Investors who have sufficient assets to generate income to support their lifestyle for the remainder of their lives have no real actuarial risk.
- Asset Class Risk
Stocks, bonds, cash and real estate are the four major asset classes. If you allocate too much of your wealth to any one class, you are subjecting yourself to asset class risk. This risk is mitigated by diversification. Research, for example, has determined that with at least 12 and preferably 20 different stocks in a portfolio, you can eliminate most company specific risk in a portfolio. However, we also know that you cannot eliminate market risk. Efficient portfolios are constructed using different asset classes that have low correlations to one another. By combining these assets together we see that in normal markets, we can increase returns and decrease risk in a portfolio through diversification. However, in market corrections or meltdowns, these different correlations tend to break down. We have seen stocks in a severe bear market decline as much as 50%, while bonds have declined as much as 10%. Note: Past performance is never to be taken as an indication of future performance.
- Opportunity Risk
This is also known as opportunity cost, which is the highest price or rate of return an alternative course of action would provide. It is the cost of forgoing a safe return such as Treasury Bills or cash for the expectation of making a larger return elsewhere. The most common form of opportunity risk is the real cost of an investor staying in cash over a market cycle when stocks or bonds outperform cash.
- Emotional Risk
One risk that often gets overlooked is emotional risk. Emotional risk is the risk of letting emotions guide investment decisions rather than using the discipline of an investment policy statement and a well thought out investment strategy. Financial advisors help clients manage their two greatest emotions within the investment arena, fear and greed. Fear causes investors to bail out of the market in a bear market and keeps investors out of the market during the early stages of a market recovery.
- Taxation Risk
With the exception of municipal bonds every investment is subject to taxation risk. However, taxation risk for municipal bonds becomes an issue if the security is sold for a profit or interest payments are subject to Alternative Minimum Tax (AMT). How an investment is held will mitigate taxation risk, i.e., if it is held inside an IRA, qualified plan or tax sheltered account. Other strategies include avoiding or minimizing short term capital gains, tax loss harvesting and using tax efficient managers.
What additional risks should be considered in the Wealth Management Process?
Wealth Management is a dynamic strategic planning process. It starts with a comprehensive integrated financial plan. After considering the investment portfolio and the risks associated with investing, we need to look at those things that can sabotage or blow up the plan and interrupt the process of converting your wealth to income during retirement; providing your family with uninterrupted enjoyment of the lifestyle to which they are accustomed; and transition of wealth to future generations and charitable causes. Risk management begins with identification of risks and deciding if they can be mitigated or transferred to a third party (insurance) or deciding if you have sufficient wealth to self-insure the risk. Here are some of the other risks that are part of the wealth management process:
- Income Interruption Risk
This involves the premature death of the primary income provider or disability of the income provider. It can be mitigated by 1) term or permanent (cash value) life insurance or 2) disability insurance. This risk no longer exists after retirement unless you are counting on earning additional income after you retire to satisfy your retirement income needs.
- Litigation Risk
This risk can disrupt plan execution by depleting retirement plan assets. It stems from three primary sources and the lack of sufficient liability insurance:
- Automobile Liability
- Homeowner Liability
- Personal Liability
- Health Care Risks
Major health care issues can also disrupt plan execution by depleting plan assets. Health care risks generally fall into two categories:
- Critical Illness Risk
- Long Term Care Risk
These risks are often self-insured or they can be mitigated by purchasing sufficient major medical and long term care insurance. Most individuals fail to properly dimension the magnitude of these risks or the likelihood that it will happen to them.
- Retirement Income Protection
Retirement income is subject to fluctuation due to market risk discussed earlier. Income strategies are available from insurance carriers to protect income and guarantee income for life at contractual withdrawal rates, even though underlying asset market values may be dissipated. Investors need to carefully examine any prospectus for these types of products before investing their money.
- Tax Law Changes
Tax laws change every few years and taxes can deplete wealth without proper planning. Strategies include holding assets in appropriate accounts, trust and estate planning and annual tax planning reviews.
Why is it important?
Failure to manage risks properly will result in the dissipation of wealth and failure to maintain current lifestyle during retirement. It may also result in your failure to leave the legacy you intended.
How can I mitigate these risks?
The first step in mitigating risks is to identify each risk which is why we schedule annual risk management reviews with our clients. Each risk is identified and strategies are discussed to either accept the risk, restructure assets to reduce the risk or transfer the risk to a third party, usually an insurance company. Let’s take the risk of litigation for example. Risk of litigation from damage or loss due to personal action, automobile accidents, or real estate ownership, can be mitigated by transferring these risks to a third party insurer by purchasing sufficient insurance or transferring assets to properly structured asset protection trusts. Comprehensive Wealth Management should include asset protection strategies delivered by competent experienced tax attorneys for protecting your wealth from frivolous law suits and unfriendly courts.