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Understand Your Investing Risk Tolerance

by sshrx_ns3li1
written by sshrx_ns3li1

Understanding your true investing risk tolerance goes much further than checking a few boxes on a risk tolerance quiz.Investment risk encompasses several broad concepts, with multiple iterations of each. Longevity risk encapsulates the possibility that you’ll outlive your money. Risk tolerance taps how much of an investment loss you can psychologically withstand. Jason Escamilla, CEO at Impact Labs in San Francisco, describes a two-step plan for tackling client risk: First, protect the client’s wealth and second, ensure they can meet their goals. When approaching risk, Escamilla incorporates both emotion and analytical risk analysis.Here are a few steps for protecting your mental health and financial wealth by understanding your risk tolerance:Define what you consider to be riskier assets.Access your risk tolerance.Categorize your risk level.Manage your risk. Defining RiskWhen discussing risk, it’s common for the investment community to focus on standard deviation or volatility of investment returns. The standard deviation of investment returns measures how far from the average annual investment returns plot on a graph. When applied to annual investment returns, past returns are used to calculate the current standard deviation.A standard deviation close to zero means that the returns are consistent and approximate the average. A certificate of deposit has a standard deviation close to zero. Invest $1,000 in a certificate of deposit, and as long as the investment is owned until maturity, the consumer receives the stated interest rate.For a riskier asset, the 10-year average standard deviation of the SPDR S&P 500 ETF (ticker: SPY) is 12.69. A higher standard deviation means that there’s a likelihood that returns will deviate from the mean, both up and down.Riskier assets, like stocks, have more dispersed returns and typically a higher standard deviation. For example, since 2008, the S&P 500’s greatest loss was in 2008, with a decline of 36.55%. While in 2013, the S&P 500 gained a 10-year record of 32.15%.An investor seeking higher returns must also accept the possibility of greater losses.Longevity risk is akin to risk capacity and relates to the possibility of an investor outliving her wealth. Wealthier individuals have a high-risk capacity or low-longevity risk. Those with more limited means have a greater chance of outliving their assets.A wealthy investor might have a low-longevity risk and still be uncomfortable with investment losses. This investor would be conservative, despite the portfolio’s ability to withstand losses.Assessing Risk“Risk tolerance is a concept that can be difficult to gauge with clients. A client's risk tolerance can change with the direction of the market. When the market is doing well, clients want to be very aggressive and when the market is experiencing some downward volatility, clients can be fearful and want to go to cash,” says Mario Hernandez, a certified financial planner at Gemmer Asset Management in the San Francisco area. Gemmer has a unique strategy to assess client risk. He educates clients with data, describing past stock market declines and then asks them how they'll sleep under those circumstances. That informs the level of risky equities to include within a client portfolio.Brandon Renfro, an assistant professor of finance at East Texas Baptist University, uses a similar approach. For older investors, he asks clients what they did during the onset of the Great Recession and then queries them about how they would react to a future stock market drop.Typical risk tolerance questionnaires ask investors about how they would respond to distinct levels of investment declines. Typical response choices include sell, hold, or buy more of the risky asset after a decline. Investors' responses attempt to describe individuals' risk aversions.But these risk quizzes are historically inaccurate and the more “in vivo” discussions of Renfro and Gemmer are likely to yield more accurate risk-tolerance levels.Categorizing Risk LevelsThe simplest way to categorize risk levels is by time. Short-term investors who will need their funds within one to four years should invest conservatively, with minimal exposure to equities and the greatest allocations to cash and short-term bonds. That’s due to the unpredictability of the stock market in the short term. Investors don’t want the $50,000 downpayment for their new home to be worth $40,000 in two years when they are ready to buy.In contrast, one might assume that long-term investors are aggressive, but that assumption is too simplistic.In the long term, over decades, stock prices trended upwards. But the positive stock market average returns over the long term mask short-term volatility. Realistically, the future is uncertain and there are no guarantees that the upward trend of stock prices will continue. That’s why assessing risk tolerance is tricky.For the mid- to the long-term investor, risk levels will vary from conservative to aggressive. The risk level is represented by the amount of loss an investor is willing to withstand. Even an investor with great wealth may not be willing to tolerate the loss potential of a stock-heavy investment portfolio.A conservative investment portfolio typically holds between 70% and 90% cash and fixed assets, with the remainder in stocks. While an aggressive investment portfolio ranges between 80% and 90% stock investments, with the remainder in bonds.The most common risk tolerance levels vary between conservative and aggressive, with conservative portfolios owning fewer stock assets and more aggressive ones owning greater amounts of riskier holdings.Managing Risk“To manage risk, we believe that it is essential to diversify your assets – whether your risk tolerance is conservative, moderate or aggressive. We recommend reviewing your investment goals, risk tolerance and time horizon with your financial professional on a regular basis to make sure they are aligned with your asset allocation,” says Chris Haverland, an asset allocation strategist at Wells Fargo in Greensboro/Winston-Salem, North Carolina. Diversification reduces portfolio volatility so that if one asset class loses value, others will offset the loss with investment gains. That’s why it’s important to own stocks, bonds and possibly other financial assets like real estate.Some investors prefer to manage risk with a passive portfolio. In this scenario, the investor maintains a constant mix of assets such as 60% stocks and 40% bonds. While others prefer to manage risk actively by adjusting investments according to market and economic conditions.Rick Lear, chief investment officer at Lear Investment Management in Dallas takes an active approach to risk management. Lear conducts in-depth research to determine which asset classes might go up. Then the firm heavily weights the asset classes projected to rise in the future, considering both the research and the economic cycle.Victor Haghani, chief investment officer at Elm Partners in Philadelphia, uses an active value and momentum-based asset allocation strategy. The unique Elm Partners algorithms manage risk by integrating value measures into their asset selection and overlaying those asset class picks with a momentum screen. All clients of Elm’s managed portfolio sign up for an asset allocation that adjusts according to an active assessment of fundamental and momentum factors.Understanding risk tolerance is an active process that incorporates personal, economic and market factors. It’s important to understand one’s time horizon, risk tolerance and risk capacity before constructing an investment portfolio. A comprehensive understanding of investment risk will minimize the likelihood of buying high and selling low.

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Business Growth

Interest-Rate Risk vs Credit Risk

by sshrx_ns3li1
written by sshrx_ns3li1

Bond markets are complex, and if investors aren’t aware of the different types of risks that affect a bond’s value, their investments can lose money.

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Fixed-income investors take two primary types of risk: interest-rate risk and credit risk, and in exchange, buyers get a return. These two forms of risk can be interrelated, but they also represent different facets of a bond’s value:

  • What is an interest-rate risk?
  • What is credit risk
  • How these factors affect current market conditions

What is an Interest-Rate Risk?

Investors take on interest-rate risk when they purchase a bond with a certain yield. There is a “chance that once you purchase an investment, interest rates will rise or fall, making the value of that investment worth more or less than when you purchased it,” says Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott.

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10 of the Best Stocks to Buy for 2020. ]

The Federal Reserve sets short-term interest rates and will raise or lower them based on economic conditions to keep inflation low. The Fed has a 2% inflation target, and if inflation remains under that level, the central bank can keep rates low. If inflation seems to be rising too fast or is holding above the Fed’s target, the central bank will raise rates.

When interest rates increase, the price of bonds falls because bond yields and bond prices move inversely to keep the value constant. Interest rates may increase on their own for a few reasons, says Bill Zox, chief investment officer, fixed income and portfolio manager at Diamond Hill Capital Management.

Inflation might be rising faster than expected, or investors may demand more after-inflation return from their bond investments. This is known as the real yield.

“It’s basically inflation expectations plus the real yield gives you your bond yield,” Zox says.

Normally, if inflation expectations increase or investors demand more return from their bond investments, it’s because the economy is strong. A strong economy usually leads to faster earnings growth, which should be good for equities.

“In a normal environment, if interest rates are increasing, the value of bonds should be decreasing and the value of stock investments should be increasing,” Zox says.

Interest rates are higher for bonds with longer maturity dates.

Maturity can be as short as a day or as long as 30 years or more, in some cases. Jason Ware, head of municipal bond trading at 280 CapMarkets, says investors can tailor how they want to expose their capital to interest-rate risk by holding bonds with different maturities.

“The shorter the timeline is, the faster you’re going to get that principal back, and you are a little less susceptible to some of that interest-rate risk,” Ware says.

What is Credit Risk

Credit risk is the chance that a bond issuer, the borrower, won’t perform its legal obligations to pay back the debt, LeBas says.

Ware says people can think of credit risk like a credit score for companies. Companies with low credit risk are not unlike people with high credit scores. Both can borrow money from banks at lower interest rates because they’re less likely to default.

When companies decide on a yield for the bonds they want to sell, they start with the benchmark interest rate, and then add more yield entice investors. That differential is known as a credit spread, and the benchmark interest rate is Treasury bonds.

Companies that have a high risk of defaulting must offer buyers a yield high enough to make the return worth with the risk. These are known as high-yield or junk bonds.

[ 

See:

Why Bonds Beat Expectations. ]

“Unlike equity managers, if you’re a bond manager, the best thing that can happen is you get your money back. When you look at credit risk, you know you are being compensated for the probability that you will not get your money back,” says Jeffrey MacDonald, head of fixed-income strategies at Fiduciary Trust International.

How These Factors Affect Current Market Conditions

Interest-rate risk influenced stock and bond market direction in 2018, when rates increased and both markets fell.

In 2019, rates fell and both markets rose.

For 2020, Zox says the key question is whether economic and earnings growth validates 2019’s strong moves in both stocks and bonds. Earnings didn’t grow much in 2019, but if earnings grow 5% to 10% this year, then, “stocks will do reasonably well, but nothing like 2019,” he says.

That could cause interest rates to increase and bonds may struggle to produce positive returns, he adds.

If earnings don’t materialize and defaults increase in 2020, then government and high-quality bonds may do well and interest rates will come down from current levels, Zox says.

“Equities and high-yield bonds, in particular, will struggle because the risk of recession will be higher and the risk of corporate defaults will be higher,” he says.

There’s always a tradeoff between what the level of interest or credit risk an investor will accept, LeBas says.

He says with solid economic conditions and corporate profitability, investors aren’t getting paid to take a lot of risks, which is why credit risk is low and credit spreads between the safest and riskiest bonds are tight.

For a point of reference, currently, the average high-yield bond is paying about 3.27% over the U.S. 10-year Treasury bond yield. While that sounds high, he says over the last five years the risk premium been as high as 8.4%.

LeBas says his firm recommends clients own higher-quality bonds with intermediate to longer terms, which he defines as five to 15 years. Since the Fed has said it will likely keep interest rates low for the foreseeable future, he believes having longer-dated bonds is a good way to hedge against potential stock market weakness.

“At a time when stock market valuations are high, a good way to buy a portfolio is to own longer-term bonds,” he says. “If (stock) valuations fall – that’s not our prediction – but if valuations fall, then those long-term bonds will generally perform well.”

MacDonald prefers to take credit risk rather than interest-rate risk because he believes longer-dated maturities don’t have enough yield to compensate investors versus shorter-duration vehicles.

[ 

See:

7 of the Best Bond ETFs to Buy Now. ]

“You can look at company fundamentals and say they’re solid enough so that the idea of a big wave or surge of defaults given the economic backdrop seems unlikely,” he says.

Increase Returns With Low Interest Rates

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