Risky Business

By Kristy LeGrande, CFA, MBA, Principal

Acclaimed investor Warren Buffet summed up risk when he said, “Risk comes from not knowing what you are doing.”  So, what is risk?  How do we measure and monitor it?  How can we protect against it?  How much risk should we take?  There are numerous types of risk in the investment world and it is crucial that investors understand these risks and take steps to monitor them. 

In an attempt to educate investors, below is a list of some of the main types of investment risk, and, importantly, how they can be prudently monitored. 

Type

Financial Risk

Definition

Risks from heavy use of leverage or unsustainable spending rate that could jeopardize corpus longevity.

Who Monitors and How is it Monitored?

Client. Monitors through financial statements, prudent decision making by Board of Directors/Investment Committee/Family Decision Makers. Innovest assists clients through education.

Type

Volatility

Definition

Return fluctuation for a given security, strategy, market or portfolio, i.e. the potential range of a change in the security’s value. Higher volatility means price can change dramatically over time in either direction while lower volatility implies less price fluctuation in either direction.

Who Monitors and How is it Monitored?

Investment Consultant. Addressed through prudent asset allocation using non-correlated assets to mitigate portfolio-level volatility. Monitors volatility at the portfolio level and fund level in quarterly reports and annual asset allocation study.

Type

Market Risk

Definition

The risk and impact of equity market moves on an investment and on the portfolio as a whole.

Who Monitors and How is it Monitored?

Investment Consultant.  Monitors through in-depth diligence and continual monitoring of each investment strategy as well as through careful portfolio construction, including the addition of diversifying, non-correlated investment strategies.

Type

Liquidity Risk

Definition

Inability to sell an investment quickly either due to terms of investment contract or thin market with limited or no buyers.

Who Monitors and How is it Monitored?

Investment Consultant. Monitors through a liquidity schedule for the entire portfolio that demonstrates the availability of invested assets over time based on specific terms of each investment.

Type

Inflation Risk

Definition

The damaging effect that rising inflation rates can have on future purchasing power and erosion of real return on invested assets.

Who Monitors and How is it Monitored?

Investment Consultant. Monitors through the portfolio return target, which is represented as the return in excess of inflation (CPI +) and tracked over time. Use of asset classes with above-inflation returns protects purchasing power.

Type

Downside Risk

Definition

Estimation of the amount of loss a portfolio could sustain as a result of a decline arising from factors that affect the market as a whole or asset classes in particular (recession, loss of confidence, geopolitical events, etc.)

Who Monitors and How is it Monitored?

Investment Consultant. Monitors potential downside risk at the portfolio level. Downside risk is reviewed and quantified annually in an asset allocation study.

Other risks for investors to be aware of when constructing and monitoring portfolios include:  tracking-error risk (an investment strategy’s deviation from its benchmark), key person risk (risk of the departure of an investment strategy’s key decision maker), headline risk (risk of adverse news stories impacting the price of individual securities, strategies, or asset classes), factor risk (risk of having intentional or unintentional factor exposures in the portfolio), interest rate risk (risk and impact of changes in interest rates), credit risk (risk related to the credit of a borrower), counterparty risk (possibility that the other party in an investment, credit, or trading transaction may default on the contractual obligation), maverick risk (risk associated with venturing outside investment best practices or engaging in overtly risky positioning or strategies, i.e. a highly concentrated portfolio), legal risk (potential financial loss due to a contract between two parties being considered unenforceable), geopolitical risk (chance that an investment's returns could suffer as a result of political changes or instability), currency/exchange rate risk (the possibility that currency depreciation will negatively affect the value of investments) and other macroeconomic risks.

Risk is unavoidable in the investment world.  It is crucial that investors determine their risk tolerances and are aware of the risks they are taking in their portfolios.  In addition, investors along with their advisors, must take steps to quantify risk when possible, understand the qualitative aspects of risk, and monitor risk on an ongoing basis.

About Innovest

For more than 20 years, Innovest has provided excellent client service as well as forward-looking, innovative investment solutions for endowments and foundations, retirement plans, and families. We are an independent provider of investment-related consulting services and work on a fee-only basis.