A different take on managing risk

As the markets continue to recover, it is time to take a fresh look at investment risk. Leading up to the financial crisis, many financial advisers were beginning to understand the importance of effective risk management in their clients’ portfolios. The crisis, of course, made “risk” synonymous with “loss.”

But now we should look at the other side of risk, which is the sense of uncertainty that comes with seeking value.

A constructive view of investment risk argues for careful allocation rather than strict aversion. If an investment manager begins to view risk in relation to its potential to add value, to be carefully allocated and diversified, it can become the foundation for constructing a sound portfolio.

The key to this risk-based investing approach isn’t to avoid all risk but instead to seek out only those risks that are recognized, rational and rewarded.

“Recognized” means understanding the nature of the risks in each particular investment. Will the investor be evaluating them primarily based on an “absolute” view of risk or a relative view of risk?

“Rational” risk taking ensures that the risks the investor is taking are intended and that the sizes of potential losses in a specific investment and in the portfolio are within the investor’s tolerance.

“Rewarded” means analyzing and measuring risks that have the potential to meet investment goals over the long term in order to determine, through regular measurement, that the investor is being adequately compensated.

Successful investors know these elements and build them into each step of the investment process — asset selection, portfolio construction and portfolio evaluation. However, the results many investors and advisers have experienced over the past several years have demonstrated that many investment managers haven’t applied these basic rules consistently and effectively.

Several topical examples help illustrate this:

Hidden portfolio concentration. Unrecognized concentration in specific securities, industries or sectors is one of the quickest ways to sink a portfolio. Disciplined portfolio construction and regular portfolio evaluation can help investors recognize components of a portfolio that threaten adequate diversification and put the portfolio at increased risk of idiosyncratic events.

Complex securities. Derivatives and other complex securities can have unique risk and return profiles, particularly in extreme market environments. Many of these securities require sophisticated modeling and investment risk analysis approaches and tools in order to ensure that the potential for downside risk is understood, intended and that the risk taken has the potential to be compensated. Investors should stick to strategies and investment managers where these tools are available and effectively deployed.

Global exposure. Similar to complex securities, exposure to global markets requires investing expertise and appropriate tools and resources in order to measure and manage the associated risks. Many developing countries continue to have high concentration in specific securities, lower liquidity and different standards for corporate governance and accounting. Strategies and managers with the right tools to evaluate these risks around the globe are the key to taking advantage of the well-understood potential benefits of global exposure with a full understanding of the risks.

Counterparty exposure. Many complex securities, and investment strategies reliant on complex securities, depend on counterparties, generally investment banks. The 2008 failure of several major counterparties increased awareness of the importance of understanding and managing counterparty risk. We think that investors should seek managers who have the capability and experience in managing these risks, or limit exposures to strategies where the underlying approach seeks to minimize counterparty exposure, perhaps limiting exposures to exchange-traded securities.

Tunnel vision. Professional investing requires looking at risk from multiple perspectives, using a variety of tools and statistics. Any approach that uses one measurement statistic to the exclusion of others — such as the highly publicized “quant” strategies of some hedge funds — is likely to fail when the market moves in a new and unexpected direction.

These examples help show the importance of building comprehensive investment risk management into the core of clients’ portfolios by seeking risks that are recognized, rational and can be rewarded.

Wylie A. Tollette is senior vice president for investment risk and performance at Franklin Templeton Investments.

Related Topics: Franklin Templeton Investments