Who is your risk manager?
Those who have heard us talk about the way in which we think about managing money will have heard us say “its all about risk”.
But what do we mean by that?
When most people talk about risk what they are really talking about is ‘volatility’. Or in other words, how much their portfolio fluctuates around its long term average.
Take a look at the two portfolios below. Both have the same average annual return but one is more volatile than the other.
Volatility can be controlled by the way in which you build your portfolio and what you put in it (a.k.a asset allocation). At Brook-Dobson Brear we refer to volatility as ‘market risk’ because it can be shaped by increasing or decreasing the allocation to different markets in the portfolio.
Brilliant, so all I need to do is toggle the percentage of equities in my portfolio and I’ve cracked this risk thing, right?
Unfortunately it is not as simple as that…
In placing too much emphasis on market risk, the traditional method of investment management has it wrong. After all, if you are patient, disciplined and keep costs down, history tells us you are almost certain to be rewarded for taking on additional market risk if you wait long enough. It could be argued that for some people, market risk is hardly a risk at all. This is why we have loads of market risk in our children’s pension portfolios and hardly any for those portfolios which are needed for expenditure in the next few years. We don’t need a psychological risk tolerance questionnaire to figure this one out!
As Personal Finance Directors our role is to be risk managers as well as investment managers. We still need to do all of the investment management that the traditional approach requires but there is so much more out there on the risk map to think about.
All of these risks need to be navigated, managed or even exploited. Some can be catastrophic to our portfolio and in our view need to be removed, for example counterparty risk (often found in structured products and other complex investments). Other risks can be wealth enhancing and should be encouraged in moderation.
Counterparty risk and investment return is often a binary relationship. Most of the time the investment product ticks along quite nicely but every now and then the counterparty (often a bank) gets into difficulties and everything is lost (Lehman brothers in 2008 anyone?). There is no reliable method of assessing the relative risk of counterparties so we simply exclude this risk from our portfolios. Similarly, inflation risk can be hugely destructive to our clients’ long term wealth if not managed properly.
Other risks are more efficiently rewarded and can be used to our advantage. For example equity market risk is one which is proven to be rewarded with additional returns and there is an understandable economic rationale for why. The same is true for credit and term risk within fixed income (bonds).
Each of our clients have a unique risk map and we are in the best possible position to understand how to navigate it. The combination of risk management, financial planning and life planning we deliver is far more powerful and precise than simply handing over a sum to a discretionary investment manager to be invested in their ‘medium’ or ‘balanced’ portfolio depending upon the outcome of a risk tolerance questionnaire.
The risk maze can be complex, but we are here to navigate our clients through it. In turn maximising their chances of making their plans and dreams for the future become a reality.
After all, isn’t that what this is really all about?
If you would like to talk to us about our Personal Finance Director service or ask about risk management, financial planning or anything else we would love to hear from you. Why not get in touch?