Thinking Risk Before Return

By HighView Financial on April 5, 2011

Unfortunately, most of the global investment industry is centred on “benchmark risk” or whether or not a manager “beats the market”.  Instead, at HighView Financial Group, we believe that wealth managers should focus on “goals-based investment risk“.  For most clients, risks are cash flow oriented: assets are invested either to provide cash flow today or in the future.  As a result, rather than matching portfolio assets to an arbitrary benchmark, most portfolios should be managed to offset future cash flow liabilities.

When constructing portfolios for our clients, we always talk about the potential future “behaviour” of their portfolio……in other words, the anticipated “ups-and-downs” of their portfolio.  This is so important to helping clients ensure that they don’t just think about potential returns (ie: upside) but also the potential risk (ie: downside) to their portfolios. We call this “The Ride”

As a result, when we’re constructing portfolios for our clients, at HighView Financial Group, we believe that:

• The management of risk, not return, is the primary determinant in structuring a portfolio

• Risk and Return are directly correlated.

 Risk

• Risks can only be managed if they are identified and understood

• Understanding risks involves assessing their probability and magnitude

• Risk of loss must be considered in terms of both income and capital

• The risk of losing money is far more important to clients than the risk of underperforming an index

• Loss avoidance is the primary risk metric to consider in designing an absolute return oriented portfolio.

• Excessive concentration exposes a portfolio to imprudent levels of risk

 Returns

• Returns cannot be managed as they are a by-product of portfolio structure and process

• Returns must be considered in terms of both income and capital.

• Excessive diversification can be very dilutive to long-term investment results.

• Clients should have a bias toward absolute returns

• Net (after cost) returns are what really matter to clients.

All of this is not to say that Returns are not important — as they are — but an investor cannot talk about Return without also speaking about Risk…they are “two sides of the same coin“.

As an example, simple mathematics proves the necessity of attempting to minimize loss. Let’s assume that there are two Portfolios: A & B.  If Portfolio A falls by 20% over a given period, it will require a gain of 25% to return the investment to pre-loss value. In contrast, though, if Portfolio B falls by 10%, the gain required reduces to 11% to return the Portfolio to pre-loss value.

This is a very important concept in today’s world of relative investing, as portfolios with strong downside/risk management protection preserve capital and can help contribute to better longer-term total returns for clients.

In other words, if investors avoid “the torpedos“, they don’t have to be aggressive on the “upside” in order to achieve attractive overall total returns!