Controlling Your Investment Risk

Risk varies inversely with knowledge.”– Irving Fisher, in The Theory of Interest, a book published in 1930

Learn why negative correlation is a positive thing

If you don’t understand negative correlation, and how it reduces risk, you may miss out on opportunities to increase returns while reducing risk at the same time.

Modern Portfolio Theory (MPT) provides an explanation of how you can reduce risk in an investment portfolio without also reducing the rate of return. It is a valuable tool. Harry Markowitz won the Nobel Prize in Economics in 1990 for work done in 1952 in developing the theory.

Negative correlation is the key. Correlation is simply a measure of the degree to which investments typically move in the same or in the opposite direction. If you have two investments with negative correlation, one will be going up in value as the other is going down. If they are positively correlated, they will both be moving in the same direction, either up or down.

When your investments are negatively correlated, you can use higher-risk/higher-return investments in your portfolio and still reduce the overall risk. This is because the risk, to the portfolio as a whole, is reduced: when one higher-risk/higher-return investment is going down, another is typically going up in value to offset the decline.

Two investments are said to have perfect positive correlation when they not only go up at the same time but also do so by the same percentage. These investments would have a positive correlation of +1. Conversely, two investments have perfect negative correlation when one goes up and the other goes down by the same percentage. This correlation has a value of –1.

Two investments have zero correlation when the performance of one is generally unrelated to the performance of the other. In this case, knowing that the first investment has gone either up or down, gives you no ability to predict which direction the second investment will take. The full range of correlation, from perfect positive to perfect negative, is from +1 to –1.

The S&P 500 Index is a commonly used benchmark for the stock market as a whole. Individual investments can be measured both in terms of how they are correlated with this index and how they are correlated with other investments.

Unfortunately, when investors are thinking of adding a new investment to their portfolio, they typically focus on the recent track record (the return) of the proposed addition. If it is good, that is usually seen as reason enough to add the investment. This is the wrong approach. A better criterion is to determine if it will reduce the risk of the portfolio. To answer that, you have to ask your advisor how the potential investment is correlated with others you already have. If the new investment has negative or low correlation with the other investments in the portfolio, it will reduce the risk to the portfolio as a whole.

One of the most important things that we learn from Modern Portfolio Theory is that we should not be concerned about the performance of individual investments. We should focus on the risk and return of the portfolio as a whole.

Bottom line: Over the long term, and under normal circumstances, there are more effective ways to reduce risk from all sources than to move the portfolio to cash or treasury bills.

What you can do now: Ask your advisor how a proposed new investment is correlated with the rest of the investment portfolio.

Have your portfolio optimized

If your investment portfolio is not optimized, you may be taking more risk than necessary for the rate of return you expect to earn.

In an optimized portfolio, the asset mix is designed to minimize risk for a certain level of return or to maximize return for a certain level of risk. Computer programs are available to help you achieve this desired mix. The computer selects investments to give the highest probability that a drop in value of one investment will be offset by an increase in value of another. (See the discussion of negative correlation in the preceding section.)

Before computers, advisors relied on experience and guesswork to reduce overall portfolio risk. For example, an oil stock might be bought in combination with an airline stock, because a drop in the value of one was usually offset by a rise in the other. Here is another hypothetical example, used to explain how risk to the portfolio can be reduced. An investor could acquire shares in a factory that makes sun screen lotion and shares in a factory that makes umbrellas. That way, regardless of the weather, one of the factories had a good chance of being profitable. If one factory was losing money and the price of its shares fell, the loss would be offset by the rise in value of shares in the factory that was profitable.

Using optimization software, the computer runs through thousands of possible combinations of stocks and recommends, for each rate of return, the combination with the lowest overall risk (lowest correlation between investments).

When your portfolio is already optimized with three or four asset classes, you can very quickly see the effect of adding another asset class to the existing mix. If the new acquisition has a high correlation with the rest, there will be almost no reduction in overall risk. If the new asset class has low or negative correlation with the rest, the portfolio’s risk will be reduced.

The most notable change in the risk-and-return profile of the average investment portfolio occurs when non-traditional investments are added to the portfolio. Some of these investments include income trusts, hedge funds, managed futures, and other alternative investments. These types of investments are “structured” investments and are run by an investment manager much in the same way a mutual fund is run by a professional manager. By asking your financial advisor, or by typing in the key words to any search engine, you can find more information about these non-traditional investments. Since they have low correlation with stocks and bonds, their inclusion increases the probability of earning a higher return without taking more risk.

In a perfect world, all investment advisors would use optimization software and all clients would have portfolios that provide the maximum return for risk taken. In reality, most advisors have not invested the time and money required to offer computerized optimization to their clients.

On a risk and reward chart, such as the one below, risk is measured on the horizontal axis and is greater as we move to the right. We have higher returns as we move higher on the vertical axis. In this chart, Portfolios A, B, C, and D are all “efficient” in that no combination of investments is available that is expected to earn a higher return for that level of risk. For investors who want a higher return and are willing to accept higher volatility (or risk), portfolio D would be best. For people who want lower returns and lower volatility, portfolio A would be best.

You do not want your combination of investments to give you the risk and return of portfolio X. In this range of risk and return, you could, by changing your asset mix, get a higher return without taking more risk by changing to the portfolio C mix. Or, you could get the same return with lower risk by changing to the B mix.

There are an infinite number of “efficient” combinations of investments between portfolio A and portfolio D. Here’s what all of these portfolios would have in common: each would offer the highest possible return for a given level of risk. When you have a combination of investments, so that it is theoretically impossible to get a higher return without taking greater risk, it is said to be an efficient combination, and it would be found somewhere along the line between A and D.

It is impossible to find investments that offer very high returns and very low risk. Given the constraints of the model, a well-diversified portfolio can never be above the A to D line. The risk and return for the portfolio of the average investor is usually somewhere near the X area. On the other hand, some of the most successful professionally managed portfolios for pension funds, endowment funds, and wealthy individuals are almost always closer to the A to D line. This line is called the Efficient Frontier.

The value of optimization is that it shows what changes should be made to an asset mix to bring the expected risk and return from X to either A,B,C, or D or some other point along the Efficient Frontier line.

Bottom line: Optimization is a useful tool, but it does not offer guaranteed returns with low risk. Assumptions still have to be made and results may not follow the historical data. Yet, optimization is one of the best ways to design a portfolio that should give you the highest return possible for a given level of risk.

What you can do now: Ask your financial advisor if your investment portfolio is on the Efficient Frontier that would exist for the assest classes you are using, and, if so, what is the expected return and risk of your asset combination.

Learn how the experts measure and control risk

Thinking that risk can’t be measured or controlled could lead you to accept a portfolio that is either too risky or not risky enough to generate the return you need.

Beauty, fear, and happiness are intangibles. They are difficult to measure. Some investors think that risk also fits that description. Such thinking makes them less likely to try to control the risk in their portfolio.

However, investment risk is a precise concept that can be measured, controlled, and reduced. In this context, risk simply means the degree to which an investment rises and falls in value.

“Standard deviation” is the most common measurement of risk. It describes the level of risk, just as liters measure liquids and kilometers measure distance. Standard deviation measures the amount by which individual annual or monthly returns deviate from the historical average rate of return of the investment.

Standard deviation provides us with a more precise way to measure the potential risk inherent in any portfolio. If the standard deviation of an investment is large, say, 20%, it is considered to be a higher risk investment. If the standard deviation is small, say, 5%, it is considered to be a lower risk investment. Historically, the standard deviation of a broad measure of the stock market is about 20%, while the standard deviation of a portfolio of government bonds is about 5%.

The higher the standard deviation, the riskier the investment. Remembering that fact is the first step in controlling risk. As an investor, you should ask your advisor to tell you the standard deviation of any proposed mutual fund investment.

If you are considering managed investments, such as mutual funds or hedge funds, it will be almost as easy to find the standard deviation as to find the price of the investment. If you are considering a single stock, you would have to work out the standard deviation yourself. If the stock has a history of monthly or annual prices, the calculation could be done in a few minutes by using a function of the Excel computer program.

It is useful to understand standard deviation because sometimes you should choose the riskier investment and, at other times, the less risky. For example, imagine that you are offered a choice between two investments. One investment has averaged 6% per year for the past five years while the other, which has had higher risk, has averaged 8% over the same time. Which investment do you choose? The problem is, you know the second investment has more risk, but you don’t know how much more risk. How risky is risky? Does the higher return justify the higher risk?

If you know that the standard deviation of the first investment is 14% and the standard deviation of the second is 16%, then you know there is very little difference in the risk. You should choose the second investment to get the higher return. On the other hand, if the standard deviations were 8% and 16%, then you should choose the lower-risk investment because the 2% increase in expected return does not justify a doubling of risk. You can make a more informed decision about which investment is better for you when you know both the average rate of return and the standard deviation.

Measuring risk allows us to predict the range of returns that a given investment can be expected to yield, whether it be over a month, a year, or a longer period.

The following only for those who want to have a greater understanding of the mathematics behind the calculation of standard deviation.

STANDARD DEVIATION

The reason we are interested in the size of one standard deviation is that, in a normal distribution, 68 times out of 100, the actual return in a given year can be expected to fall in the range of (average return + 1 standard deviation) and (average return – 1 standard deviation)

For example, if an investment has a standard deviation of 15% and an average return of 8%, this means that 68% of the time the actual return in any given year will be 8% plus 15% for a total of 23% or 8% minus 15% for a total of –7%.

It turns out that 95% of the time, the actual return will fall within the range of two standard deviations above or below the average. Therefore, in this example, an investor could be 95% confident that the actual return would be within the range of –22% to +38%. That is, (8% –15% –15% = –22% and 8% + 15% + 15% = +38%)

Note: Standard deviation is only one measure that can be used to measure risk. One problem with this measure is that it does not distinguish between upward volatility, which we like, and downward volatility, which we do not like.

Bottom line: Risk is measured by standard deviation. Over the past century, the standard deviation of common stocks has been about 20% and the standard deviation of bonds has been about 5%. You should know that risk can be measured and controlled.

What you can do now: Ask your financial advisor to estimate the risk of your portfolio.

Use “risky” investments to make your portfolio safer

If you have only low-risk investments, your expected long-term average return will be lower and the annual volatility of your investment portfolio will be about the same as a well-diversified portfolio.

Most investors with a basic understanding of investments believe that higher returns are associated with higher risk. This is true when considering investments of a similar class, but not always true when looking at the entire portfolio. For example, in a portfolio of medium-term corporate bonds, the bond with the highest return is probably the bond with the highest risk. Also, in a collection of large capitalization Canadian equity mutual funds, the fund with the highest return likely has the highest risk.

However, when you combine two or three asset classes that have low correlation with each other, it is in fact possible to increase the returns of the portfolio as a whole while still reducing risk for the portfolio as a whole.

The potential return of the overall portfolio is higher because it includes investments that have a higher return history. Yet the risk is lower because historically one of the investments will be rising in value at the time when other investments are falling in value.

How does this work? It is quite simple. For practical purposes, risk is defined as the degree to which the entire portfolio falls in value in any one period. When the fall in value of one investment is almost entirely offset by the rise in another, the portfolio as a whole has lower risk.

Using different types of investments to reduce risk is called diversification. It has always been the best way. What is different today is the availability of optimization software that can measure more precisely how effective one investment is at offsetting the downward movement of the other investments in the portfolio. By doing an Internet search using the key word “optimization,” you can learn more about this type of software. For most investors it makes more sense to ask their financial advisor about optimization than to invest in the software themselves.

A common mistake that should be avoided is to over-diversify within the same asset class. For example, it is not uncommon for investors to own 10 different Canadian equity mutual funds in the mistaken belief that this number of funds gives them adequate diversification. In fact, because all of these funds buy the same Canadian stocks, they are likely to be highly correlated and therefore provide very little real diversification. In most cases, an investor who owned one government bond, one Canadian equity mutual fund, one “fund of hedge funds,” and one income trust would have a better level of diversification than these investors.

Sir John Templeton, creator of some of the world’s largest and most successful investment funds, understands how important diversification is when he says: “The only investors who shouldn’t diversify are those who are right 100% of the time.”

Bottom line: If risky investments have low or negative correlation with other investments in your portfolio, they should not be rejected automatically just because of their higher risk. By combining higher-risk/higher-return investments that have low correlation with each other, the drop in the value of one investment should be cancelled out by the rise of another. The risk of the portfolio is not increased but the portfolio still gets the benefit of the higher-return investment.

What you can do now: Stop using past performance as the criterion for selecting new investments. Start focusing on how, and to what degree, the proposed investment will reduce the risk of the portfolio. You do this by asking how the new investment is correlated with the existing investments. Look for investments that have low correlation with the rest of your investment portfolio.

Never be fooled by a fund’s average return

When you decide to buy a mutual fund based primarily on the fund’s average return, you may be buying a fund that has greater risk than you think.

When investors select mutual funds they often do so based on the historical average annual return. In the best case, they look at a five-year average annual return, and in the worst case they look at one-year returns. The problem is that one-year returns or five-year average returns do not provide enough information to make an intelligent investment decision. For example:

• The average return tells nothing about the volatility of the fund. How bad was the fund in the worst year? Remember you can drown in a lake with an average depth of two feet. It is the deep spots that cause problems but their depth is obscured by the average depth statistic.

• The drawdown is what you should be interested in. The drawdown represents the amount you could lose if you bought at the top and sold at the bottom. The drawdown will always be worse than the worst calendar year loss. For example, a fund is having a good year and is up 10% for the first six months. An investor buys in at the end of June only to see the fund start to fall in value. By the end of the year the fund shows a 15% loss for the year. In this case, the fund would show a loss of 15%, but the investor who bought at the top had a loss of more than 25%. (The fund went from being up 10% to being down 15%.)

• Look at annual returns rather than an average return. Over a 10-year period a fund is unlikely to ever earn the average return in any single year. The actual annual return will almost always be higher or lower than the average return.

• Does the fund have the same manager? If not, the average means nothing.

Bottom line: Looking at the average return does not enable the investor to estimate the amount the fund can drop in value in any one period.

What you can do now: Ask to see the annual returns and ask about the largest drawdown – the amount of the loss from a peak to a trough.

Ask yourself how you would cope with a major investment loss

Losses are always more painful than expected. If you don’t understand how you will react in the face of mounting losses, you may be in a portfolio that is too risky for your psyche.

Studies over the years have measured the emotional impact on people who have gained or lost in the market. Among other findings, the studies show that the intensity of the pain and grief from a loss is much greater than the intensity of the joy experienced from a gain of the same percentage.

The joy of an unexpected gain is quickly absorbed. Financial objectives are often adjusted to include the unexpected return as part of your base capital. Within a few months, you have spent the gain or forgotten about it.

The anxiety of an unexpected loss can go on for along time. People think about losses a lot, blaming themselves or their advisor. They ruminate over how the loss will affect their lifestyle, and planned date for retirement, what spending should be curbed, and how the loss can be explained to friends or family. The pain can linger for many years (and even longer if the spouse had advised against the investment).

A large loss may bring fear, panic, and an anxiety that further losses could occur. This fear will cause many people to bail out at the worst time. To survive the down times, an investor needs to have a plan in place and complete confidence in the investment strategy that is being used.

Gains may trigger overconfidence, but I’ve never seen them cause panic. It is panic that causes the uninformed investor to make costly mistakes.

The investor who feels the sudden dread of loss is usually not alone. Many others with the same holdings feel the same way. Their reaction is to sell. This additional selling forces prices lower, which causes even more investors to want to sell. The prices keep going lower until almost all those who are nervous and fearful have finally capitulated and sold their investment.

When the risk-tolerance questions are being asked in the advisor’s office, the average investor has no idea how he would react in the face of mounting losses. The risk-tolerance questionnaire gives the client the false sense of comfort that he is in the portfolio that is right for him. The question to ask your advisor is: “What would have been the worst percentage loss any year during all of the last century in a portfolio with the same asset mix that you are proposing?” Since it is easier to live with percentage losses than real dollar losses, you should also convert this worst-possible percentage loss into real-dollar terms.

For example, assume that your advisor tells you that in the worst year this asset mix dropped in value by 20%. Also, assume you are retired and you have capital of $500,000. A 20% drop in value would mean a $100,000 drop in the value of the portfolio. If the asset mix being proposed to you has declined by this amount historically, you should assume that it will decline by at least the same amount at some point in the future. If you are not comfortable with this level of decline, you should be invested in a more conservative asset mix.

Bottom line: Do not underestimate the feelings of panic that would strike if your portfolio falls in value and your retirement security seems in jeopardy. You must diversify so that losses will be limited. And you should have a good idea of how large the worst-case loss is likely to be.

What you can do now: Ask your financial advisor how your asset mix would have performed over the last 100 years. Assume that there will be another event that will cause your portfolio to perform at least as poorly, if not worse. If you are not comfortable with the potential downside, ask your advisor to rebalance your portfolio.

Consider disaster protection

You should be prepared for anything and everything. Based on the history of bull and bear markets, you should expect that the bear market that follows one of the greatest bull markets in history (from 1982 to 1999) could be at least as bad the average bear market that occurred during the past century.

A wise investor will reduce the risk of disaster. Most advice to investors, however, is based on the assumption that the markets will continue to operate in a well-ordered and normal manner. But what if world events lead to markets not behaving normally? For example, what if markets around the world all drop drastically and the economy goes into another depression such as in the 1930s?

If there is a global market crash, we can expect that most investments will become positively correlated. This means that they would all plunge at the same time. In these gloomy circumstances, the only investments that are seen to be risk-free are cash and treasury bills. Some advisors and books suggest that you include non-financial assets such as gold coins, art, antiques, and collectibles as part of your investment portfolio.

The effect of the majority of investors wanting to sell all of their stocks would be a surplus of products for sale with almost no buyers. Everything would fall in value. Investors might interpret the situation as a call to panic stations. The calls to their advisors would overwhelm the switchboard with instructions to sell immediately.

Although this scenario is far removed from the prevailing view, nothing should be taken for granted. Some investment managers, regarded by their peers as highly intelligent, predict that the next crash will be the big one. If nothing else, their forecasts make for riveting reading.

Bottom line: Good diversification, especially if done using optimization software, will reduce risk during normal circumstances. In a major market collapse, however, even this may not be enough to protect your capital. To protect yourself in these circumstances, you may need other assets, such as cash, precious metals, and gold coins.

What you can do now: Read a “disaster” book to get a different perspective from what you normally hear from always bullish and optimistic financial advisors.

Beware of stocks that can double in value

Why this is important: If an investment rises suddenly in value, it is a high-risk investment; the probability of a large fall is closer than it was before the sudden rise.

Investors are delighted when their stock investments rise in value by 50% or 60% over a short period of time. However, there’s a caveat. Most investments that move up quickly are high risk and they can go down in value by the same amount even faster.

This stock has most likely moved because of speculation. Unfortu-nately, extreme moves upward are usually followed by equally sudden moves in the opposite direction. Instead of this extraordinarily high return turning on the green light for further investing, it should turn on, if not a flashing red light, at least a cautionary yellow light.

With a properly designed portfolio, you should not expect surprises. Surprise is often caused by incorrect data, or sloppy calculations. Wrong assumptions can bring either upside or downside changes. Do not count on being lucky twice in a row.

Bottom line: If you have a stock or other investment that has just enjoyed a sudden move upward, you should ask your financial advisor to explain the reason.

What you can do now: Take a very close look at any investment that has enjoyed an unexpected high rise in value over the last few years. Expect that an unexpected rapid rise will be followed by an adjustment that will bring it to a value lower than its true value.

Learn how hedge funds may reduce risk

Not knowing how hedge funds can be used to reduce risk may mean that you are taking more risk than necessary to earn your expected rate of return.

The marketing materials for hedge funds almost always focus on their potential to reduce risk in an average investment portfolio.

Hedge funds have characteristics sufficiently different from the three traditional asset classes – stocks, bonds, and cash – that they are considered to be a separate asset class.

Hedge funds are hard to define. They do not fit into a single, short, and neat definition because under the hedge fund umbrella are many diverse types of investment structures. A general description is that a hedge fund is an investment vehicle, often in the form of a limited partnership, that may employ a variety of investment strategies including the use of leverage and short sales.

There are many different styles of hedge funds and some do not necessarily “hedge” at all. Sometimes called alternative investments, hedge funds have some similarities but many differences when compared with mutual funds. Since most people understand mutual funds, an understanding of hedge funds can be had by looking at the differences between hedge funds and mutual funds.

As distinct asset classes, both hedge funds and mutual funds can include some very bad, overpriced, and risky funds, as well as stable funds that give above average returns with lower than average risk. Just as some people lose money by buying the wrong equity mutual fund, some people will lose money by buying the wrong hedge fund.

Hedge funds can be broadly classified into three different types according to the strategies they employ and the expected level of risk and return.

• The riskiest hedge funds are in the “opportunistic” category and are described as “return enhancers.” That is to say, the main reason for including opportunistic hedge funds is to increase the return of the portfolio as a whole.

• The lowest-risk hedge funds are under the “relative-value” category and relative-value strategies are used to reduce risk.

• In terms of risk, the middle category of hedge funds is the event-driven category; hedge funds in this category, sometimes called “diversifiers,” are used to increase the diversification of the portfolio as a whole.

There is substantial evidence to show that portfolio risk will be reduced and the return will be increased, if 10% to 30% of the portfolio is invested in a number of different types of hedge funds. The reason for this is that hedge funds usually have low or negative correlation with stocks and bonds and therefore can reduce risk for the portfolio as a whole.

Hedge funds are not new. They have been around for more than 50 years. Until recently, however, they were available only to wealthy and professional investors. The packaging and marketing of hedge funds has changed. They are available now in amounts as low as $5,000, and many versions also come with full capital guarantees.

The following chart shows a comparison of some of the features of hedge funds and equity mutual funds.

Ask your advisor this question: “What is the expected risk (measured as standard deviation) of my existing investment portfolio and how would that risk change if I moved 20% of the portfolio into hedge funds?”

Two of the best books on the topic of hedge funds are: Absolute Returns: The Risk and Opportunities of Hedge Fund Investing by Alexander Ineichen, and Managing Risk in Alternative Investment Strategies by Lars Jaeger. These books are texts for the Certified Hedge Funds Specialist program.

Caution: In recent years there has been a rapid increase in the number of hedge funds that are available to the general public. In some circles, hedge funds have become the new in-thing, and as their popularity and demand increases, some less scrupulous and less competent managers will start hanging out their shingles as hedge fund managers. This poses a serious risk for the uninformed investor because hedge funds are not regulated the way mutual funds are. The hedge fund manager has the freedom to invest almost any way he chooses and the average investor may have no knowledge of what a particular hedge fund is investing in at any given time. If a manager makes a mistake, and some hedge fund managers will make mistakes, the resulting loss is likely to be much greater than the loss that would result when an equity mutual fund manager makes a mistake. When buying hedge funds, make sure that your financial advisor understands the different types and the different levels of risk associated with each one.

Bottom line: Most experts believe that the coming decade will be a difficult one for investors. Some experts predict that as hedge funds become better understood, they will become the investment of choice for investors who want to minimize risk.

What you can do now: Ask your financial advisor for information about hedge funds and read educational materials issued by the Alternative Investment Management Association (AIMA) website: www.aima.org/