Special Feature

Risk’s rewards

In part one, understanding clients' risk tolerance. In part two: How you can explain the uses of many different types of risk when building your client portfolios. In part three: Explaining the role of diversification and asset mix in reducing your clients' investment risk.

If clients have a good understanding of the investment risks they are taking, they won't worry so much about their portfolios

By Dwarka Lakhan | Mid-February 2013

Helping your clients to learn about the risks associated with investing is a daunting task. But, at the same time, it's a vital one if your clients are to reach their investment objectives.

Most investors see risk as being bad, says Brian Smith, vice president and portfolio manager with Fit Private Investment Counsel Inc. in Toronto, viewing risk only in terms of losing money. Clients often stop short of seeing the good side of risk - that, in general, higher risks carry higher potential returns.

"It is hard for clients," Smith says, "to understand the different types of risk."

But if your clients understand the investment risks they are taking to achieve their goals, they will be less inclined to worry about their choices and thus decide to remain invested for the long term.

This would also make it easier for you to explain gaps that could arise between your clients' expectations of how their portfolios should perform and the actual performance of their investments during volatile market conditions.

"Risk becomes a problem only when it is unintended, misunderstood or uncompensated," says Wylie Tollette, senior vice president of investment risk and performance with Franklin Templeton Resources Inc. in San Mateo, Calif.

Tollette recommends that you intentionally take risks that you and your clients fully understand and for which your clients are compensated.

For example, Tollette explains that you might recommend that your client invest in an Australia-based mining company, based on your positive outlook for the sector and the Australian economy. However, you may discover that the performance of this company is highly correlated to that of a China-based company - in which case, the risk you are taking becomes unintentional.

You should take a holistic approach based on your client's financial plans, suggests Gaétan Ruest, assistant vice president, product and corporate research, with Investors Group Inc. in Winnipeg.

Ruest says the underlying question that must be answered is: "What are the risks of your clients not achieving their financial objectives?"

In responding to this question, Ruest says, you must be able to determine why your clients have a certain level of risk tolerance.

Market risk is the primary risk to which your clients are exposed. And although this risk typically is associated with variability in stock prices, it has several components including equity, inflation, currency, interest rate, credit, liquidity, counterparty and capitalization risks.

Equity, inflation, currency, credit and interest rate risks are associated with the possibility of change in the investment value over time.

For example, equity prices will vary, credit quality may decline and foreign exchange, inflation or interest rates will change, thereby affecting the value or performance of your clients' investment portfolios.

The impact of each of these risks, says Smith, depends on the exposure your clients' portfolio has to them.

Capitalization risk is tied to the size of the investee company.

"Large companies tend to be less risky and less volatile," Ruest says. "Small companies may outperform because they have more growth potential."

However, Smith cautions, small companies can be less liquid, which introduces liquidity risk into the portfolio.