Risk tolerance and time horizons are central topics to both financial planning and investment management. In volatile market periods, risk tolerance is put to the test, like a ship’s captain during a big storm. Over the last decade, liberal use of both fiscal and monetary policies by our federal government have suppressed market volatility. Though these efforts were positive for equity markets (if you focus on the above-average returns during that period), the decreased volatility in risk assets has unfortunately “insulated” many investors. As a result of investors’ notoriously short-term memories, their risk tolerance may be out of balance with their current portfolio. For example, the NASDAQ stock index, which reflects many technology firms, is down 21% over the past 12 months. While individuals may feel amenable to higher levels of risk on paper, in practice, they often find themselves losing sleep or experiencing other anxieties over fluctuations in asset values. If you have found this to be true recently, we may be overdue for a conversation.
In a Harvard Business Review article by Robert Kaplan and Anette Mikes titled Managing Risks: A New Framework, the authors categorized corporate risks into three categories:
- Preventable Risks: Risks arising from within the company that generate no strategic benefits
- Strategy Risks: Risks taken for superior strategic returns
- External Risks: External, uncontrollable risks
Applying these same three categories more specifically to the investment management realm, we would re-define the categories as such:
- Preventable Risks: Risks arising from over/underweight allocations to more volatile asset classes such as equities, or asset concentrations (i.e. lack of diversification).
- Strategy Risks: Risks taken by the investment manager’s asset allocation over/underweights compared to peers or an appropriate
- External Risks: External, risks out of the control of an investment manager, such as economic recession, broad market selloffs, pandemics, and geopolitical conflicts
Preventable Risks should be addressed using a well-defined time horizon that helps determine the appropriate asset mix. At Sterling Financial Group, we often use what we call a “Bucket Approach”, which primarily divides client assets into various buckets, based on the expected time horizons of future financial needs. Cashflow needs in one to five years, for example, should not all have the same investment allocations as funds that won’t be accessed for 10+ years. Shorter time frames generally lead to higher allocations in lower volatility assets such as bonds or cash-like investments. Conversely, longer-dated time horizons should lead to an increased allocation in equities.
Strategy Risks are mitigated or exacerbated through investment advisors’ selection. Scaling up or down respective allocations and sector investments are a way that strategy risk either leads to alpha or detracts from the overall performance.
External Risks are an inevitable fact of life. When bear markets take hold, knowing that both Preventable and Strategic Risks have been addressed appropriately, one can ride out the storm or even look for opportunities as they arise.
It has been difficult to enjoy the 2022 roller coaster so far, but we confidently move forward with better days in mind. Client portfolios are positioned well, and the economy resiliently pushes forward. We wish you all the best in the fall season!
(Kaplan R. and Mikes A. (2012, June). Managing Risks: A New Framework. Harvard Business Review. https://hbr.org/2012/06/managing-risks-a-new-framework)