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Beginner’s Guide to Uncovering Hidden Dimensions of Risk In Client Investment Portfolios

A well-diversified investment portfolio is a key component of any financial plan and as an experienced financial advisor, you know that risk is inherent in any investment. However, there are often hidden risks that can impact your clients’ portfolios and asset management in ways you may not expect. 

Many clients come to their financial advisors with an idea of what they want and how much risk they are comfortable taking. However, advisors often find that what their clients say is not what they mean. For example, some investors may indicate that they are comfortable with volatility but they may have underestimated the potential for losses in their portfolio or the impact of market events on the correlation in their holdings. 

In order to help your clients make the best decisions for their portfolios, it is important to uncover all of the risks that may be present. This includes not only the traditional measures of risk such as volatility, but also hidden risks such as correlation risk, concentration risk, tail event risk, and shortfall risk among others. 

Failure to do so may lead the client to react negatively when the markets get choppy and make it hard to stick to their financial plan resulting in the client terminating the relationship with the advisor and in the worst case, a lawsuit.

That’s why it’s so important to uncover all the potential risks when assessing a client’s portfolio. By doing so, you can develop a more comprehensive strategy for managing those risks and behaviors proactively.

Hidden Dimensions of Risks in Investment Portfolios 

The difference between volatility and risk

In order to dive deeper into risk, we first need to know that while Investment risk and investment volatility are often spoken about as if they are the same thing, they are actually quite different. Investment risk is the chance that an investment will lose money, while investment volatility is a measure of how much an investment’s price fluctuates which includes gains as well as losses. Volatility is often measured by something called standard deviation, which is a statistical measure of how widely prices vary from the average (not to be confused with Mean Absolute Deviation or MAD, more on that in a different blog post). While higher volatility generally means higher risk, there are other factor exposures to consider, such as correlation, concentration, and tail events. For example, two investments with high volatility might actually be less risky if they tend to move in opposite directions (that is, they have a low correlation). In short, investment risk and investment volatility are not the same thing, and it’s important to understand the difference when making investment decisions.

In addition, clients may be expecting financial advisors to actively manage portfolio risk when in reality the financial advisor may be managing volatility. Having risk systems that help identify risk factors and their potential impact on portfolios can help financial advisors more effectively manage client expectations.

A deeper dive into risk factor exposures can reveal hidden drivers of risk, investment insights and overlooked opportunities to have meaningful conversations with clients about the benefits of letting their financial advisors do the asset management. By understanding how each risk factor exposure is impacting the portfolio, advisors or portfolio managers can help clients make better decisions about what risks to take and where to allocate their money. This article will explore four dimensions of risk, how they can impact your client portfolios, and the ways to explain them to your clients. 

  1. Correlation Risk

  2. Tail-event Risk

  3. Concentration Risk

  4. Volatility Risk

Correlation Risk

Diversification relies on low correlation between different asset classes. For example, if stocks and bonds have a low correlation, then owning both will help reduce the overall volatility of a portfolio. But what happens when the correlation between asset classes changes? This is called correlation risk.

For example, let’s say that you have a portfolio that is 70% stocks and 30% bonds. The historical average correlation between stocks and bonds is 0.3, which means that they have tended to move in opposite directions. This diversification has helped reduce the overall volatility of the portfolio. But what happens if the correlation between stocks and bonds increases to 0.6? This would mean that they are moving in the same direction more often, and the diversification benefit is gone. While there is no perfect solution to this risk, investors can use a variety of techniques to mitigate it.

One common approach is to construct portfolios with non-correlated asset classes that have the potential to zig when other assets zag. Alternatives like private equity, managed futures and commodities can provide diversification benefits as they have low correlation to traditional asset classes like stocks and bonds.

Tail-event Risk

Despite the perception of safety from diversification, seemingly disparate asset classes can move in unison during declining markets leading to coordinated loss events that are higher than expected. For example, while U.S. stocks and foreign stocks have historically had low correlation, they both sold off sharply during the global financial crisis in 2008.

Tail-event risk is the risk of losses that are larger than what is typically expected. While it is impossible to predict when or where these events will occur, they can have a significant impact on portfolios. For example, the stock market crash in 1987, often referred to as Black Monday, was a tail event that caught many investors off guard. While tail events are rare, they can have a profound impact on portfolios and should be considered when making investment decisions.

There are a few ways to mitigate tail-event risk. One is to allocate assets across a variety of asset classes and investment strategies that have the potential to perform differently during periods of market stress. Another is to use hedging techniques, such as put options, which can help protect against downside risk.

Concentration Risk

Concentration risk is the risk of having too much exposure to a single asset, sector or investment. This is different from diversification because even if an investor is diversified across asset classes, they can still be concentrated if they have too much exposure to a specific investment within an asset class. For example, an investor who has a portfolio of stocks may be diversified across different sectors, but if they have a large position in one stock, their portfolio would be considered concentrated.

There are a few ways to mitigate concentration risk. One is to limit exposure to any one investment, sector or asset class. Another is to use stop-loss orders, which can help limit downside risk. Finally, investors can consider using hedging strategies, such as put options, to protect against concentrated positions.

 

Volatility Risk

Volatility risk is the risk of losses due to an increase in market volatility. This type of risk is often measured by standard deviation, which is a statistical measure of how much an investment’s return fluctuates around its mean. However, it’s important to differentiate between downside volatility and upside volatility. Downside volatility is the risk of losses, while upside volatility is the risk of not meeting investment goals. While investors typically focus on downside volatility, it’s important to consider both when making investment decisions. Lowering upside volatility exposure may result in clients needing to take on more risk to meet their goals in the future. It is essential to look at each investment and understand if it has gains or losses as market volatility changes can help investors make more informed decisions.

There are a few ways to mitigate volatility risk. One is to invest in assets that are less volatile, such as bonds or cash equivalents. Another is to use hedging strategies, such as put options or short selling, which can help protect against downside risk while proving as much exposure to upside as possible.

Next, we’re going to look at ways to uncover the different dimensions of risk in an ETF or an investment portfolio.

Looking for a deeper risk analysis? StratiFi can help. Our software is designed to help financial advisors track and manage portfolios, and our team is always happy to offer a demo. Contact us today to learn more.

How to See the Hidden Risks of ETFs and Portfolios

One way to uncover the hidden risks of an ETF or portfolio is to run simulations. There are a few different ways to do this, but one approach is to use a Monte Carlo simulation. This type of simulation uses historical data to generate thousands of possible future scenarios. This can help investors see how a portfolio might perform under different market conditions and identify hidden risks that they may not have been aware of.

Another approach is to use a risk analysis tool like PRISM Rating by StratiFi. This type of approach looks at the underlying factors that drive investment returns. This can help investors identify hidden risks that are associated with different factors.

Correlation risk for ETFs and Portfolios

Correlation risk looks at exposure to different asset classes. Looking at the rolling correlation of the portfolio with different asset classes can help investors identify hidden risks. For example, if an ETF or portfolio has a high correlation (>.8) with the equity market over the last 6 months, it may be more volatile during periods of market stress. On the other hand, if an ETF or portfolio has a low correlation (<.2) with the stock market, it may provide some diversification benefits during periods of market stress. Understanding the correlation of a portfolio of different investments with a variety of asset classes can be challenging. However, with financial advisor software tools like StratiFi this type of analysis can be done really easily.

Tail event risk for ETFs and Portfolios

Tail event risk looks at the risk of losses during periods of extreme market volatility. This type of risk is often measured by Value-at-Risk (VaR). VaR measures the amount of loss that an investment is expected to incur over a certain period of time, given a certain level of confidence. For example, a 5% VaR would indicate that there is a 5% chance that an investment will lose more than the VaR over a certain period of time.

This risk factor complements correlation analysis because it captures the risk of losses during periods of high market stress when correlations go to 1, even if the investment has a low correlation to the overall market it may still have a significant loss during events like the global financial crisis. ETFs can be exposed to tail event risk because of the underlying investments they hold. For example, an ETF that tracks commodities, which can be exposed to tail event risk because of the high volatility in commodities prices. Or a low volatility ETF that may be exposed to tail event risk because of the high concentration of a few stocks or sectors. A bond ETF may be exposed to tail event risk because of the inherent interest rate risk in bonds.

Concentration risk for ETFs and Portfolios

Concentration risk looks at the risk of having too much exposure to a single stock, sector, or asset class. This type of risk can be hidden because it’s not always obvious from looking at an ETF or portfolio. For example, an ETF that tracks certain sectors may have a high concentration of a few stocks. Or an ETF that tracks the S&P 500 may have a high concentration of a few sectors. Another example is a portfolio of 50 different stocks that may have just a few stocks that have a weighting of over 20%. Leveraged ETFs often have high concentrations of a few stocks or sectors as well.

There are a few different ways to measure concentration risk. One way is to look at the weighting of the top 10 holdings in an ETF or portfolio. Another way is to look at the Gini coefficient, which measures the inequality of a distribution. A high Gini coefficient (>0.8) indicates that a few holdings have a high weighting, while a low Gini coefficient (<0.2) indicates that the holdings are more evenly distributed.

The PRISM Rating from StratiFi can help investors identify ETFs and portfolios with hidden concentration risk.

Volatility risk for ETFs and Portfolios

Volatility risk is the risk of losses during periods of high market volatility. To measure this type of risk we have to understand how the constituent investments perform and whether they have gains or losses during periods of high market volatility. To do this we can look at the performance during high volatility periods and check to see if the underlying holding had gains or losses. For example, Inverse ETFs will have the opposite performance of their underlying index during periods of high market volatility, and hedged ETFs should minimize the impact of market volatility on the losses.

There are additional factors like credit risk, interest rate risk, and liquidity risk among others that financial advisors should consider when evaluating alternative investments, mutual funds, actively managed funds, and passive strategies.

How Financial Advisors Can Help Clients Mitigate Risk And Improve Outcomes

Financial advisors play an important role in helping investors mitigate risk and improve outcomes. 

There are a few different things that financial advisors can do to help investors:

1) Educate investors on the different types of risk and how to measure them

2) Help investors identify their goals and objectives

3) Create personalized portfolios based on an investor’s risk preference and tolerance

4) Monitor portfolios on an ongoing basis and make adjustments as needed

For example, many investors don’t know that there are different types of risk, or how to measure them. Financial advisors can educate investors on the different types of risk and help them understand how it can impact their investment portfolio. If investors don’t understand risk, it can impact their behavior, leading to sub-optimal outcomes.

Investors also need to have realistic expectations for returns. Many investors think that they can achieve high returns without taking on any risk. However, this is often not the case. Financial advisors can help investors understand the trade-off between risk and return, and how to create a portfolio that meets their risk preference and risk tolerance.

Creating a personalized portfolio by accounting for risk preference and tolerance can help investors create a portfolio that is tailored to their specific needs and goals. A deeper analysis of risk can help advisors justify management fees, and also help clients sleep better at night knowing that their portfolios are designed to weather different market conditions.

Ongoing monitoring of portfolios is also important. Portfolios will go through different stages as the markets change, and it’s important to make sure that the investments in the portfolio are still aligned with the investor’s goals. Financial advisors can help investors monitor their portfolios on an ongoing basis. Portfolios need to be rebalanced as market conditions change, and financial advisors can help make sure that portfolios are on track to meet investors’ goals

Softwares like StratiFi can help financial advisors monitor portfolios on an ongoing basis and make adjustments as needed. StratiFi’s PRISM Rating can help advisors identify ETFs and portfolios with hidden concentration risk. By monitoring portfolios on an ongoing basis and making adjustments as needed, financial advisors can help investors mitigate risk and improve outcomes.

Regulatory Bull’s Eye

No discussion about investment risk is complete without considering regulations. The compliance function at many Investment Advisors is currently grappling with new regulations such as the SEC’s Custody Rule and Regulation Best Interest.

The SEC’s Custody Rule applies to registered investment advisors who have custody of client funds or securities. The Rule requires advisors to have special safeguards in place to protect client assets. Advisors must also maintain records of client assets and provide clients with periodic statements.

Regulation Best Interest, or Reg BI, is the SEC’s new rule that requires financial advisors to put their client’s interests first when making recommendations.

The rule has three main components:

1) Disclosure – Advisors must disclose their fees, conflicts of interest, and the type of relationship they have with their clients.

2) Care – Advisors must exercise reasonable care when making recommendations.

3) Conflict of Interest – Advisors must avoid or mitigate conflicts of interest.

The disclosure component requires financial advisors to provide clients with information about their fees, conflicts of interest, and the products they recommend. This information must be presented in a way that is easy to understand and compare.

The careful consideration component requires financial advisors to consider a wide range of factors when making recommendations, including the client’s investment objectives, risk tolerance, financial situation, and other factors.

The conflict of interest component requires financial advisors to avoid or mitigate conflicts of interest when making recommendations. For example, if a financial advisor is recommending a product that pays them a higher commission, they must disclose this to the client.

The rule applies to anyone who provides investment advice to clients, including brokers, registered investment advisors, and insurance agents.

A deeper risk analysis helps with Reg BI because understanding the client’s real risk profile can help Investment Advisors show that their recommendations align with the customer’s best interest. Financial advisors may be able to justify certain products if they address specific risk factors that are important to the client.

Technology is changing the way that advisors interact with clients and manage their portfolios. New tools and platforms are making it easier for advisors to collect data, analyze risk, and make recommendations.

Financial planning software and risk analysis software can help advisors understand a client’s financial situation and goals. This information can be used to create a personalized financial plan that includes recommendations for investments, insurance, and other financial products.

Portfolio management software can help advisors track a client’s portfolio and make sure it is properly diversified. This software can also help advisors rebalance a portfolio as market conditions change. A review of the portfolio risk during client annual reviews can help validate that the client’s risk profile has not changed.

 

Key Takeaways

The first step to managing risk is understanding it. Financial advisors can help investors understand the risks associated with their investment portfolios.

There are many different types of risk, including correlation risk, concentration risk, tail event risk, volatility risk, interest rate risk, credit risk, liquidity risk, and regulatory risk.

Technology can help financial advisors collect data, analyze risk, and make recommendations. Financial planning software, risk analysis software, and portfolio management software can all be used to manage client portfolios.

Investment insights on risks can help clients and their financial advisors have more informed conversations about the best way to protect and grow client assets.

When it comes to investments, there are always going to be risks involved. However, by understanding the different types of risk and how to manage them, investors can put themselves in a better position to reach their financial goals.

Finally, a deeper understanding of risk can help financial advisors align their recommendations with their client’s best interests. This is especially important under the SEC’s new Regulation Best Interest rule.

  

What are some of the hidden risks in your client portfolios?

Do you have a good understanding of the different types of risk?

How do you educate clients about risk in their portfolio?

Akhil Lodha Author
Co-founder & CEO StratiFi Technologies

Building the industry standard for understanding portfolio risk through cutting- edge technology at Stratifi.

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Additional Advisor Resources

Bob Veres features StratiFi in ‘Inside Information’ February 2022 Edition

Bob asks, “Is it really possible that a portfolio risk assessment tool for wealth managers could be as sophisticated as the algorithms that institutional teams are using?”

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