Over the last couple of decades, institutional risk management has become an integral process at almost every large organization. Corporate risk managers concern themselves not only with financial risks, but with strategic and operational risks as well, evaluating possible future outcomes and their effect on their organizations.
The International Standards Organization has even attempted to standardize the process of organizational risk management, defining it as "the effect of uncertainty on objectives." It defines risk management as "the identification, assessment and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor and control the probability and/or impact of unfortunate events."
While these definitions look good on slide presentations at corporate risk management departments, they are probably a bit too abstract for the real world practice of managing assets for people. Still, they offer a framework to systematically evaluate and manage client risk. By explicitly defining what could happen, focusing in on the uncertainties and estimating costs, it's possible for investors to minimize and control their impact.
Most individuals, too, and their advisors are already managing risk in their investment process, even if they don't know it. Specifically, they try to curb the risk of suffering shortfalls when it comes time to cover future liabilities. The insurance they buy protects them against certain rare but costly events. But saving and investing is a type of insurance as well-essentially it's self-insuring against all other future liabilities, trying to prevent catastrophes in the future that you can't predict and whose magnitude is uncertain.
The goal of diversification is to manage liquidity and uncertainty in the asset class returns of a client's portfolio to cover future expenditures.
There are two ways we can tweak a portfolio to meet liabilities. First, after identifying and segregating uncertain future liabilities, we can match them to assets that are highly correlated with them. Second, we can imagine different scenarios that help us manage those risks better by ensuring sufficient liquidity.
The interesting thing about this approach is that, besides helping us prepare for catastrophe, it also gives us a higher overall portfolio return-because the risk profile is now better defined.
People can buy insurance in preparation for a number of horrible circumstances. They can insure against death, disability, health problems and medical emergencies, property loss and legal trouble. They can also partially insure things such as educational outlays (through prepaid tuition plans) and retirement income (through annuities). Of course, there are also catastrophic risks such as war, natural disasters and the government confiscation of property that can't be insured against-things that would hurt almost every asset class if they came to pass. But since there is no feasible way to manage these events short of building a survivalist compound stocked with food, weapons and gold bars, we will ignore them.
What we manage instead is the uncertainty in future asset values by putting them next to comparable future liabilities. We take investment risk and then divide it into further components of inflation risk, market risk, interest rate risk, credit risk, liquidity risk, etc. The historical effects of these risks on the returns of various asset classes are quantified as annual standard deviations, which are then used to compare the "riskiness" of expected returns.
Defining Risk With Investment Goals
Clients can manage their investment risk typically by building a diversified portfolio with an allocation and assets that seek the highest return for the client's risk appetite. Usually, the risk profile is defined as how tolerant the client is for losing money when he will need it to meet a few large defined expenditures: retirement, education costs, a house, etc. After an investor takes these liabilities into account, he invests the rest of the portfolio for preservation of capital on the one hand and growth on the other, with income sought somewhere in the middle. Defining other future liabilities and the risk associated with them allows an investor to lower his risk of a future asset shortfall.
Rather than thinking in growth or income terms on the investment side, the investor must separate out expense streams and allocate a portion of the portfolio to more closely track these expenses over time. The largest non-discretionary expenses incurred by most households are for housing, taxes, energy and food. To manage the risk that these expenses will increase, investors can pick assets that more closely track them than a diversified investment portfolio would. In addition, if an investor anticipates other future liabilities and estimates when they might occur, he can create an investment allocation that better minimizes the risk of potential shortfalls. He could, on the other hand, well come up short if he simply estimates expected asset class returns, correlations and annual standard deviations.
There is one other advantage of this approach: Investors who don't use it might otherwise be sacrificing return by keeping the overall risk level of their portfolios too low. They aren't taking the proper time horizon into account and they could be mistakenly misallocating assets in excess of their future non-discretionary needs. They are more likely to assail their overall risk if they tackle the individual components of risk separately, allocating portions of their portfolio to retirement income, education savings, living expenses and estate planning. Not only will they be managing their risk better, but they will also be better able to use what assets remain, maximizing their long-term non-essential discretionary spending for things such as philanthropy, bequests, collecting or lifestyle. If a client separates these assets from particular savings goals, he will be more likely to invest them in more illiquid long-term investments with a higher expected return.
Managing Risk
To use this risk framework, an investor must first insure risks of uncertain but improbable events such as premature death and disability, catastrophic medical costs or property loss. Next, he should segregate out and invest specifically for future liabilities with unknown costs: for example, retirement income, education costs and living expenses. Since the risk associated with these unknown costs is primarily related to inflation (not necessarily CPI inflation), the diversified portfolio for each will have to contain asset classes with a higher expected return than inflation. Additionally, the shorter the time horizon, the more heavily weighted the portfolio should be to assets that directly track the inflation of the costs specific to the liability.
Take household expenses. It is now possible to use commodity ETFs that track the same futures used by corporate risk managers to hedge against future household price increases. Similarly, if an individual doesn't own real estate but he might have future housing needs, he can find liquid real estate investments that will reduce his exposure to future housing inflation without giving him the liquidity risk of holding actual real estate.
For principal protection against inflation as measured by CPI, an investor may turn to Treasury Inflation-Protected Securities, but he might also consider ETFs or assets with a lower tracking error than TIPS-for example, gold for general dollar risk or international currencies and bonds for specific non-dollar exposures.
Then there are school expenses. Since higher-education costs are rising faster than the returns of all the asset classes, the only effective way an investor can eliminate the inflation risk for them is by using a prepaid tuition plans. Unfortunately, these limit the student's choice of college or university (just one of their drawbacks).
After an individual identifies and isolates specific future liabilities and their associated risks, he can manage the remainder of his assets with more traditional mean variance portfolio theory. But even here, it helps us to categorize our risks as we diversify the portfolio.
Some assets are illiquid. Some are vulnerable to tax changes in a charged political environment. Others depend on the asset manager's diligence and integrity. It may help an investor to hold international assets, for example, whether they are outperforming or not, simply because it reduces exposure to the U.S. dollar and domestic political changes. Alternatives carry their own risks. Many come burdened with lockup periods. There is also a higher risk of fraud and inaccurate marks and the risk that the manager will drift from his stated objectives.
This kind of asset matching requires investors to ponder different scenarios. It's easy now to look back at the housing crisis, for instance, yet difficult for investors to model scenarios for similar cataclysms in the future. For example, the risk of home ownership is not just the potential downside of the residential real estate market, but the possible liquidity squeeze if there is a mortgage involved and the principal exceeds the possible sale price. It is easier to imagine severe downturns in the real estate market now than it was a few years ago. But there are still other downside risks considered unlikely now that would require an investor to tap into his liquidity at an inopportune moment.
Insurance can cover some of these risks. But investors have to put thought into more complex financial situations and see how the risks and risk mitigation strategies are interconnected. The liquidity and duration of a portfolio should be determined not just by an asset allocation model and expected expenses, but by careful consideration of all that could go wrong and what decisions would have to be made if they did.
Scenario modeling means asking a client to imagine what would happen if she lost her income, her stock options sank and her home dropped 30% in value. That kind of question will give her a much better indication of her risk tolerance than a Monte Carlo analysis of her proposed asset allocation.
A retired client and I pursued an investment planning process using this risk management strategy. We identified his major risks as inflated living expenses and potential long-term care liabilities. We allocated a portion of his portfolio for inflation protection and anticipated a long-term and significant drop in equity values (a five-year decline and a drop of 50%). Even under those conditions, he still had sufficient assets to protect against most worst-case liabilities.
After taking into account these risk scenarios, we found ourselves with an asset allocation very different from what the standard age-based model would have proposed. In this case, the client preferred to take more investment risk than an advisor would normally recommend. But given the potential bad outcomes and his acceptance of those risks, the portfolio offered a higher expected return for his estate, which was his priority after he'd allocated adequate assets to cover his future liabilities.
In this case, we did not consider the potential loss of Social Security income as a risk. It could be, unfortunately, that someday we have to.
In the institutional world, risk management is an integral part of money management. But individual investors mostly manage their risk implicitly, using insurance and some portfolio diversification. Instead, they could be segregating their non-insurable future liabilities and mitigating their risks separately by matching their assets to highly correlated obligations.
With the advent of exchange-traded funds and notes for currencies, commodities and other alternative asset classes, it is now possible to perform risk management of this sort for individuals. But risk management also means focusing on all the cataclysms a person faces in life, not just his investment risks. Understanding and planning for these risks and their potential correlations is just as important in the investment process.
Michael J. Reed is president of M.J. Reed Investments, a Bridgewater, Conn.-based RIA firm. He was a former director in Morgan Stanley's Process Driven Trading unit.