Advisors and their clients head into 2014 with some positive tailwinds at their backs. Strong market performance has led to increased investor confidence and a renewed focus on growth – as evidenced by significant equity flows last year.by the record $352 billion received by all U.S.-listed equity mutual fund and ETFs last year.1
As advisors conduct portfolio reviews, the positive market performance likely means good news for many clients’ account balances. Perhaps more importantly, it also presents a timely opportunity for advisors to engage clients in meaningful discussions about investment risk.
Changing the risk conversation
A survey of global investors released in September by Natixis Global Asset Management shows that investors are increasingly focused on growing assets. Of the 750 U.S. investors surveyed, 70% say asset growth is becoming more of a priority, but 76% admit they don’t have a solid understanding of the risk in their own portfolios.2
We have seen elements of this dynamic before such as the tech bubble fallout of the late 90s and the most recent financial crisis. Investors have focused on growth, but lacked the necessary knowledge about risk. In each instance, advisors wish they had seen the signs so they could have tried to avert calamity. This time, there is a chance to do just that by having open, frank discussions with clients about risk – and the nature of those conversations needs to be different than in years past.
A steady, unwavering focus on risk should be the centerpiece of your next review with each client, particularly as more of them gravitate back to stocks. It’s critical for advisors to review clients’ portfolios and provide guidance as to whether they may be taking on too much or too little risk.
Identifying an investor’s risk tolerance and designing a portfolio that performs within that range can help investors benefit from rising markets and minimize setbacks in downturns. The most important question: is their risk level is appropriate given their long-term goals and their time horizon. Rather than being thought of as something to avoid, risk should be approached as a precondition to earning investment return.
The advisor’s role here is to ensure that all of a client’s investment risks have a specific purpose. Every investment carries the possibility of loss or potential for gain. An effective portfolio evaluation will give advisors and their clients a better understanding of which assets will tend to reduce risk and which are more likely to enhance return. If an asset does neither, it shouldn’t hold a place in the portfolio.
Recent surveys reveal that many investors tend to be passive about risk. After making an initial decision about asset allocation, they tend to lock in, making adjustments only around the fringes of their portfolios. They let the ups and downs of the market determine the makeup of their portfolios without realizing that they are also skewing their risk levels.
Avoiding risk pitfalls
At Natixis Global Asset Management, our team of portfolio consultants increased the number of model portfolios examined for financial advisor clients last year. Our goal is to help advisors provide durable portfolios that limit risk and manage volatility. We have found that, while advisors do an admirable job of diversifying assets by style, those holdings can often have similar risk characteristics. A concentration of risk in the portfolio can be like holding too much of a single asset – it can make a portfolio more susceptible to market swings.
Analyzing model portfolios can help advisors spot correlated asset classes (those that move in relation to one another) and identify suggestions that can help diversify the portfolio. It can also help advisors put a value on client risk. So, in the same fashion that an advisor can review client returns or asset allocations, the models can also be used as a tool to assess the value of risk.
The most useful move an advisor can make for their clients right now is to conduct a thorough risk “inventory,” and help them understand what modifications may need to be made. To paraphrase the popular saying, we are doomed to repeat history if we choose to ignore it. This time, however, by better managing risk, advisors can help their clients change the script and write a happier ending.
1TrimTabs Investment Research, (www.trimtabs.com), Daily Liquidity Report, December 17, 2013.
2Natixis Global Asset Management, 2013 Global Survey of Individual Investors.