Most clients see risk as being "bad" because they consider only downside risk — the chance an investment will post negative returns in the short term. These clients fail to see the "good" side of risk, or upside risk — the potential for higher returns over time.
Investors might be more inclined to assume risk and post positive returns over the long term if they had a better understanding of risk.
"Risk and return are at the heart of investing," says David Andrews, vice president of portfolio construction at Franklin Templeton Investments Corp. in Toronto. If clients do not assume risk, they are likely to realize "an uninspiring rate of return."
When making asset-allocation decisions, Andrews says, the goal is to generate an optimal rate of return to meet the objectives of your clients. "We manage the risk exposure we take," he says, to provide downside protection and maximize portfolio returns.
Therefore, it is important to educate your clients about risk so that they can be comfortable with it. You must first take into consideration each client's level of risk tolerance: "conservative," "moderately aggressive" or "aggressive."
Here are three ways you can help your clients better understand how to take advantage of risk:
> Explain risk vs volatility
"There is no single, perfect way to measure risk," Andrews says. But there are ways to assess a security's potential risk. One way is to look at volatility.
Clients often equate risk with volatility, Andrews says. However, risk and volatility are not the same. Risk involves the possibility of a permanent loss of capital, while volatility refers to the ups and downs of the market or the price of a security. Clients can actually benefit from volatility by buying a security when its price is in the low portion of the cycle.
Volatility, Andrews says, is typically measured by standard deviation, which looks at variations in the price of a security over a specified period. But this measure does not distinguish between upside and downside variations. So, clients should not simply view a security with a high standard deviation as "risky." A volatile stock that displays frequent, sharp fluctuations in price might still increase in value over the long term because the underlying company has strong fundamentals.
> Mitigate risk
Explain to your clients that portfolio diversification is one way to mitigate risk and provide downside protection, Andrews suggests. Ideally, in a well diversified portfolio, losses suffered by some securities are offset by gains made by others. If the securities in a portfolio are not correlated to each other, the chances of a decline in the total value of a portfolio are minimized, because all sectors do not move in the same direction in a given market cycle.
You can also minimize risk by avoiding concentrated portfolios, which make large bets on specific securities or sectors.
> The importance of securities selection
Clients should avoid buying securities when valuations are too high, Andrews says. "They should be priced right," he says — that is, relative to their historical values. Securities that are valued fairly have a lower chance of dropping in price or losing their value in a market decline.
Clients also should take into consideration the liquidity of securities, Andrews says. They should ask themselves: "Can I get out?" or sell a security if they choose to do so.
This is the first part in a two-part series on risk. Next: Risks faced by retired clients.
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