Understanding & Minimizing Investment Risk

Investors tend to become complacent with risk when markets are stable, and trending upward, such as we witnessed from 2003 to 2007. It’s in years like 2008 that investors are reminded of the critical need to understand and minimize their investment risk. As Warren Buffet once said; it isn’t until the tide goes out that we see who has been swimming with their trunks off.

Unfortunately many individual and professional investors alike fail to implement a comprehensive risk management strategy. Most risk management strategies are an afterthought and a good example of the saying “too little too late”. Failing to adopt a risk management plan from day one can lead investors to become paralyzed in rapidly falling markets.

Experienced risk analysts, money managers, and stock and bond traders will tell you that individual investments can fail even when you’ve done all the research and have all the data on your side. The key to successful investing is to make sure the size of your failures does not outweigh the size of your successes.

So the question is: How do you limit the size of your investment mistakes in order to achieve the highest return for the lowest risk?

Diversification is Not EnoughAsset allocation (sometimes referred to as diversification) is not enough. The problem is that during a severe downturn or financial panic all major asset classes can decline at the same time. Long term Capital Management for instance was a hedge fund managed by two Nobel Laureates. They had some of the most sophisticated models in the world and yet ultimately failed miserably. One of the core flaws was that they relied too much on diversification. They failed to recognize the size of the ripple effects on many of their investments after the Russia devalued their currency.

Many investment professionals also saw the subprime mortgage problem years in advance. What many failed to understand was the ensuing liquidity crisis that would cause the value of just about every investible asset class to collapse simultaneously in the 2nd half of 2008. Once again diversification failed. This does not mean that diversification is a bad thing; only that it is not enough.

SureVest’s 7 Step Risk Management ProcessThere is no such thing as a risk-free portfolio. Risk exists on many levels from investing in all cash to all stocks. At Surevest Capital Management, we utilize a seven step risk management process to help protect our clients.

Step 1 - Utilize Modern Portfolio Theory to Create an “Efficient Portfolio"
Harry Markowitz won the Nobel Prize in economics for Modern Portfolio Theory by demonstrating how to combine different types of investments (often called asset classes) in order to reduce risk without reducing returns. This debunked the notion that if you wanted higher returns you had to accept more risk. The idea is to combine investments which all have positive long term trends but which don’t all go up or down at the same time.

We minimize the volatility of your portfolio by having some investments that are going up when others are going down. The percentage which is allocated to each type of investment is determined, based on historical data regarding how the prices of each asset class moves in various market conditions. The planned percentage that you decide to put in each type of investment is referred to as your “strategic asset allocation”.

For many investors and advisors this strategic allocation is their entire risk management plan. The model is set at the beginning and then simply rebalanced periodically. At Surevest, it is just the beginning.

Step 2 - Overweighting or Underweighting Asset Classes Based on Current Market Conditions.
Financial publications call this a “tactical overlay”. As mentioned above, the strategic allocation is how assets move based on past data. This does not necessarily mean they will move this way in the future. We believe that real-time economic data and current valuations also need to be taken into consideration.

For example; supposed the plan is to have 15% of your portfolio in US Large company stocks. However US large company stocks are currently overvalued relative to other asset classes. We would most likely reduce the percentage we invest there and move some of that money to an asset class that is undervalued. Once the valuations drop in US Stocks we could then move back to the 15% allocation. On the flip side if we see deep value in US Stocks, we may decide to invest a higher percentage of assets in this area. We make these types of overweighting and underweighting decisions in each area of your portfolio and are constantly reassessing risk and reward.

Step 3 - Pairing Passive & Active Strategies
Steps one and two have helped us determine what percentage of your money should be allocated to the different investment areas at any given time. Then we must choose the specific investments for each area. What specific individual investments should be used to fulfill the commodities allocation, the emerging market debt, the managed futures, the real estate, the US small cap stocks, and so forth?

Some money managers believe in passive management which means they only use investments which are designed to mirror the performance of an entire category of the market such as large company US stocks(typically using Index Funds / ETFs). The alternative is active management where your money manager picks individual stocks, bonds or other investments which they feel provide more upside potential or less risk than investing broadly in the entire category. Both active and passive management has pros and cons. At Surevest, we use both passive and actively managed investments. This enables us to have the broad diversification of investing in the category (also known as the index) but also enables us to potentially outperform or minimize risk by investing in individual companies which would hold up well in the face of certain expected challenges (i.e. inflation, credit crunch, etc.). We firmly believe that active risk management will be necessary for anyone looking to achieve superior risk adjusted returns in the foreseeable future.

Step 4 – Limiting Position Size
You can only lose what you invest. Enron, WorldCom, and other such disasters remind us that position size is critical. If Enron were only 1% of your portfolio you could have made that loss back in a day or two with normal market fluctuations. If Enron were 25% of your portfolio it would probably taken several years to recover that loss. At Surevest, we limit position sizes to no more than five percent in any one individual company, to help protect our clients. Our average position size is between one and two percent of a clients portfolio.

Step 5 - Daily Monitoring
We believe that managing an investment portfolio is a full time job. You or your advisor should be able to react at a moment’s notice to real time market information. Should an accounting scandal arise there could only be moments to react to specific news. For this reason our portfolio managers monitor market data on a real time basis and can react immediately when necessary.

Step 6 – Thorough Research
Many investors too often become married to one method of analyzing investments. At Surevest, we believe that the more information we can utilize the better. Our approach utilizes three different types of analysis: quantitative (numbers and ratios), fundamental (products, markets and management), and technical (price movement and trading volume). When we use all three types of analysis, we are able to identify investments where valuations are compelling, management and business models are superior, and technically, volumes and money flow confirm our conclusions.

Step 7 – Hedging Market Risk in Significant Downturns
Every once in a while our financial markets experience a severe correction, such as we saw in 2008. These types of markets can drive down assets prices far lower than what we determine to be their “fair value”. The “buy and hold” strategy can be devastating in times like these.

There is a slogan that says “don’t fight the trend”. There are times to participate in market gains and times to protect those gains. We utilize time tested technical analysis techniques designed to identify these severe corrections early and then quickly reduce or hedge our exposure. Surevest uses our seven step process described in this article in an effort to reliably grow and protect our client’s wealth over extended periods of time. We do not attempt to track indexes or find hot stocks that can make or break us. Our clients will be much further ahead if we can simply capture a good percentage of the upside while significantly limiting the downside vs. those with a portfolio that simply tracks what the markets do or lives and dies based on a few “hot” stock picks.

For More Information :If you have questions or comments about this or other financial issues, please contact Jeremy Kisner, CFP at (480) 272-7116. Mr. Kisner is the President of SureVest Capital Management (www.svwealth.com), a fee based financial planning and wealth management firm with offices in Las Vegas, NV and Phoenix, AZ.