Investment Risk: What It Is and How to Manage It
There are no rewards from investing without some measure of risk. Risk management, a process for recognizing, assessing and prioritizing a variety of risks, is an essential part of managing a portfolio successfully. Cedar Hill takes a holistic approach to risk management by identifying each client’s objectives, preferences and constraints, then creating specific asset allocation and implementation strategies to minimize the effects of negative events.
In the article below, Cedar Hill Managing Director Chris Engelman explains the firm’s perspective on risk and how it mitigates risk in client portfolios.
What is investment risk?
Investment risk includes quantitative and qualitative factors. We use quantitative analysis to evaluate an investment’s range of outcomes under different scenarios and how volatile results may be during the investment’s holding period. Although historical performance is an important consideration when measuring quantitative risk, past performance does not guarantee future results. Therefore, we also consider qualitative risks in our analysis. Qualitative factors include the portfolio’s concentration in any single position or investment strategy, the client’s liquidity needs for expected and emergency expenses, and other unique circumstances specific to each client. There is no magic formula to measure if a portfolio is taking too much risk. Instead, it’s important to take an all-inclusive approach to risk management that factors in an individual’s goals and objectives as well as the consequences if the portfolio doesn’t meet expectations.
How do you evaluate an investment’s risk level?
Before making an investment, we evaluate the probability of losing money and the magnitude of potential losses over the investment’s expected holding period. We prefer investments that not just offer a strong chance of making money, but also are likely to limit losses if our initial thesis turns out wrong. Our analysis generally covers a three-to-five year period, since temporary hiccups may occur and it’s important to consider the investment’s long-term potential. While stock prices will move up and down during the holding period, it is the potential for permanent impairment of capital that concerns us most.
Does an investment’s risk change over time?
Absolutely. The fixed income market is a great example of how risk changes over time. Investors have historically relied on bonds for capital preservation and income generation. With interest rates hovering near all-time lows, the income bonds are producing today is not only significantly below the yields they generated just a few years ago, but also is not enough to keep pace with inflation in many cases. As a result, many fixed income investors have either increased the maturity of their bond portfolios, which exposes the allocations to greater price declines if rates rise, or reduced credit quality, which could backfire if default rates increase. With investors forced to either own bonds that are unlikely to preserve their purchasing power or increase interest rate or credit quality risks, fixed income investing today is riskier than it has ever been.
What can be done about these changing risk dynamics?
This is where Cedar Hill’s opportunistic investment approach comes into play. Over the past few years, we have identified new investment strategies and modified existing strategies to take advantage of changing market dynamics. Specifically, to generate more portfolio income, we created an Equity Income strategy. The strategy owns a portfolio of high-income-oriented equities that currently produce about an 8% dividend yield, though stock prices are still subject to market fluctuations. While the strategy focused heavily on master limited partnerships (MLPs) four years ago, we have diversified into other strategies, including business development companies. Additionally, for qualified clients, we continually adapt our approach to utilize alternative investments in hedge funds, private equity and real estate to take advantage of new attractive opportunities.
How do alternative investment risks differ from traditional stocks and bonds?
Many alternative investment strategies appear to have less risk than traditional public equities based solely on historical volatility measures. Alternative investments bring risks that traditional investments don’t have, including: less liquidity, hard-to-value assets, and leverage that magnifies results (both positively and negatively). To mitigate some of these additional risks, alternative strategies have implemented best practices that traditional equity and fixed income managers don’t use, such as third-party administrators and annual audits. Cedar Hill has been investing in these strategies since 1997, giving us significant experience evaluating their unique risks.
Any final thoughts on risk?
Although it’s impossible to eliminate investment risk, investors can reduce their overall portfolio risk by choosing diverse investments with different inherent risk factors. By keeping in close contact with our clients and understanding the risks they are able and willing to take, we can match their objectives with appropriate investment strategies that mitigate risk in their investment portfolios.
© Cedar Hill Associates
