How You Can Help Your Clients Shape Risk to Their Advantage

 Many investors grew risk-averse following the 37 percent one-year decline in U.S. equity values during the financial crisis of 2008. They shifted their portfolios disproportionately from equities and other higher-return assets to cash and fixed-income securities that might be less volatile but with returns too low to allow them to achieve their long-term financial goals.

While the avoidance of risk after the financial crisis has abated somewhat – flows into equities have been growing lately – many investors remain cautious. A recent NGAM survey found that 58 percent of U.S. investors say they will take on only minimal investment risk,[1] even if doing so means sacrificing returns. This approach, while understandable, may be short-sighted for many investors.

Although some concern about risk is reasonable and prudent, extreme avoidance of risk can distort a portfolio and dramatically lower returns. Risk, after all, is not simply an undesirable byproduct of investing but a precondition to earning investment returns. Rather than be avoided, risk should be managed.  

Consequently, the challenge to investors is not to avoid all risk but to insure that the risks they accept are (a) intended, (b) understood, (c) quantified, and (d) compensated. These are the fundamental qualities of a portfolio that can accommodate appropriate levels of risk while still generating the returns that are necessary for investors to reach their goals.

In fact, risk is one of the most important determinantsof investment returns. The issue for investors is how much risk they can tolerate, and which risks provide the best prospects for attractive return at the time. Importantly, investors tend to be more sensitiveto risk than returns and more likely to react – and overreact – to it on an emotional level; this necessitates setting risk related boundaries so their thresholds are not breached.

Furthermore, from the perspective of the typical investment portfolio, risk historically has been a far more stable variable than returns. If, for example, you compare the rolling five-year results for returns and risk for four common asset classes: U.S. bonds, international developed market bonds, global large-cap equity bonds and global small-cap equity bonds, you will find that the results for returns are highly volatile[2]. In contrast, the results for risk, as measured by the standard deviation for the same asset classes over the same periods, are much more consistent. Investors who userisk as the basis of their portfolios could find that it provides a more predictable foundation than returns. Putting risk first can help to achieve more consistent results that are matched with client expectations.

One reliable method for incorporating risk into portfolio construction is risk budgeting. Used properly, risk budgeting empowers investors to exploit riskto their own advantage, rather than being bystanders struggling with forces beyond their control.

When developing a risk budget, investors, typically guided by their advisor or other wealth professional, need to identify a personal risk tolerance and then quantify that tolerance to generate an allotment of risk that is “spent” in pursuit of returns. In this way, risk is redefined as something from which you can garner benefit rather than something that should be avoided. By setting limits through a budget, investors and their advisors can seek to maximize the returns for each unit of risk “expended.”

Moreover, asset allocation decisions are made on the basis of an entire portfolio instead of its individual components. Risk is managed, diversification becomes both a tool and a goal[3], and assets are viewed not as individual pieces but from the viewpoint of their overall role in a portfolio – to help reduce risk or enhance returns.

Once an investor’s risk tolerance has been identified, an overall risk budget determined, decisions around how much of the risk budget to expend on which assets depending on the relative prospects made and a portfolio constructed, the focus turns to maintenance. The investment environment is rarely static for long, and allocations need to be adjusted when an investor’s situation or market conditions change.

This adjustment is especially important in times of volatility. Given the agreement on risk-based terms between advisor and client, if the portfolio exceeds its prescribed risk limits, steps must be taken to bring it back in line. The failure to take this last step was really what devastated so many portfolios in the wake of the financial crisis.

Risk budgeting is a core principle of Natixis Global Asset Management’s Durable Portfolio Construction investment philosophy, which helps investors and advisors enhance efforts to construct portfolios that can endure volatility and generate acceptable returns while avoiding the kinds of losses that can damage a portfolio. Durable portfolios, after all, are what investors need to withstand the vicissitudes of today’s markets while still making progress toward their goals.

Matt Coldren is executive vice president of the Client Solutions Group for Natixis Global Asset Management in Boston.

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This material is provided for informational purposes only and should not be construed as investment advice.

Natixis Distributors L.P. is located at 399 Boylston St, Boston, MA 02116