Perspectives on Risk - Interactive Brokers · 2015-04-14 · The perspectives that matter to you ....
Transcript of Perspectives on Risk - Interactive Brokers · 2015-04-14 · The perspectives that matter to you ....
Perspectives on Risk
Critical Conversations on Risk Management
Risk depends on perspective
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Risk depends on perspective
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The perspectives that matter to you
You Your
Financial Advisor
Your Investment Manager
“Risk is not being able to retire.”
“Risk is the standard deviation of a portfolio.”
“Risk is relative performance versus peers.”
vs.
vs.
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Articulating your view of risk
Do you think of risk as: Crossing a certain asset level?
Probability of loss?
(e.g., downside deviation)
Negative impact to their goals?
54%
46%
-27% return
17%
83%
Volatility? (e.g., standard deviation
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Lower returns have made risk important again
Source: Morningstar, Inc. as of 12/31/13. US Stocks represented by S&P 500 Index. US Bonds represented by Ibbotson Intermediate Government Bond Index. The value of equity investments are more volatile than other securities. Fixed income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Equity index returns assume reinvestment of all distributions and unlike mutual funds, do not reflect fees or expenses. It is not possible to invest directly in an index.
Average Annual Returns by Decade
9.5%
6.2%
1980-1999 2000-2009
17.9%
-0.9%
1980-1999 2000-2009
US Stocks
80-year average
9.4%
80-year average
5.4%
US Bonds
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Agenda
Traditionally how the financial industry looks at risk
Risk management beyond traditional measures
Working with your advisor to create a plan
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Traditional risk measures
Traditional risk measures
Industry generally defines risk as volatility Standard deviation
• Measure of the total volatility (risk) of your portfolio • How widely a portfolio’s returns have varied around the average over time
Source: Bloomberg.
Returns Returns
Pro
babi
lity
Pro
babi
lity
Higher Standard Deviation Lower Standard Deviation
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Traditional risk measures
Volatility – A Symptom of Market Turmoil # of days the S&P 500 returned
less than -2% at least +2% 2011 21 14
2010 10 12
2009 28 27
2008 41 31
2007 11 6
2006 0 2
2005 0 0
2004 0 0
Before Feb 07, there were 949
trading days without a 2%
decline
Source: Bloomberg, Yahoo Finance, Inc. as Dec 30, 2011. *949 days represents from Feb 2003 - 2007. Performance is historical and does not guarantee future results.
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Bank Loan
Ultrashort Bond
-35%
-30%
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
0% 0.5% 1% 1.5% 2% 2.5%
Traditional risk measures
Measure risk as standard deviation (volatility)- optimize the risk/return
Limitation: Volatility does not capture all the sources of risk!
Least Risky Asset Classes Based on Volatility Heading into 2008
Ret
urn
Risk (Standard Deviation)
Short-term Municipal
Short-term Bond
Short-term Gov’t
Source: Morningstar. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Asset classes are represented by the corresponding Morningstar categories.
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Traditional risk measures
Limiting losses is key to financial success Downside Risk
• Variability of returns that fall below the average expected return Downside Capture
• Average return of a portfolio manager during negative index quarters divided by average return of benchmark during negative quarters
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Traditional risk measures
Breaking Even
-50% +100%
Investment loss Return needed to breakeven
-1% 1.01%
-5% 5.3%
-10% 11%
-20% 25%
-40% 67%
-50% 100%
-60% 150%
-70% 233%
-90% 900%
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9.6% 8.0% 6.2% 5.7% 6.6% 7.8% 6.8% 7.3% 6.3% 6.2% 6.2% 2.3% 0.8%
10.1% 5.0% 4.6% 6.6%
1.1%
-30.2% -35%-30%-25%-20%-15%-10%
-5%0%5%
10%15%
Traditional risk measures
Downside risk’s limitation: We only know the downside (tail risk) that has been previously experienced
2008 example: Floating Rate never had a down calendar year till 2008, -30%.
Bank Loan Category Annual Returns (1990-2008)
Source: Morningstar. Results shown are for the Morningstar Bank Loan Category. Past performance is no guarantee of future results.
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Risk management beyond traditional measures
Risk beyond traditional measures
Credit Analysis Diversifying by Sources of Risk Portfolio Stress Testing – understanding risk sources Hypothetical Trading
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High correlations can signal potential risk
Correlation Measure of strength of the linear return relationship between two assets and their
movement Can be any value between +1 and -1
Fund 1 Fund 2 Fund 3 Fund 4 Fund 5 Fund 6 Fund 7
Fund 1 1.00
Fund 2 0.90 1.00
Fund 3 0.80 0.93 1.00
Fund 4 0.84 0.80 0.75 1.00
Fund 5 0.75 0.77 0.72 0.83 1.00
Fund 6 0.22 0.21 0.16 0.27 0.22 1.00
Fund 7 0.60 0.63 0.61 0.63 0.63 0.49 1.00
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Traditional diversification contains mostly equity exposure
0.98
0.12
-0.02
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
Stock Returns Change in Interest Rates Change in Inflation
Cor
rela
tion
Correlation of Traditional 60/40 Portfolio to Risk Sources Over the Last 15 Years (1999-2013)
Sources: BlackRock; Bloomberg. Traditional 60/40 portfolio composed of 60% S&P 500 Index and 40% Barclays Aggregate Index, rebalanced annually. Stock returns are represented by the S&P 500 Index. Change in interest rates represented by the monthly change in the 10-Year Treasury Yield. Change in inflation is represented by the Consumer Product Index. Past performance does not guarantee or indicate future results. It is not possible to invest directly in an index.
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Understanding risk sources – portfolio level
More risks need to be considered Inflation Risk Interest Rate Risk Credit/market Risk Liquidity Risk Currency Risk Political Risk
Portfolios need to be diversified by risk source!
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Understanding risk sources – Inflation
15-Year Correlation with Inflation (Top 10, all Morningstar categories)
Source: Morningstar, as of 12/31/12. Past performance is historical and does not guarantee future results. Asset class representation are that of Morningstar. Inflation is represented by the US Bureau of Labor Statistics, CPI All Urban. Correlation over other time periods might not be as favorable.
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0.35
0.32
0.27
0.20
0.17
0.16
0.12
0.11
0.11
0.10
0% 10% 20% 30% 40%
Floating Rate
Commodities
Ultrashort Bond
High Yield Municipal
Natural Resources
Energy Equity
High Yield Bond
Latin America Equity
Long/Short Equity
Inflation-Protected Bond
Deflation Categories Long Gov’t -0.25 Long Bond -0.17 Intermediate Gov’t -0.14 Short Gov’t -0.10 Intermediate Bond -0.05
What do you think will happen to these stocks if the price of International Oil Company +69.5% Housing Developer +14.8% Movie Rental Service +11.9% Online Auction Service +9.7% Online Travel Agency +8.0% Telephone/Communications Company -13.6% International Beverage Company -16.4% Chain Restaurant -23.3% Airline -26.2% Discount Department Store -41.0%
What happens if the price of oil suddenly rises ~60%? Int’l Oil Co. Housing Developer Movie Rental Service Online Auction Service Online Travel Agency Telecom Co. Int’l Beverage Co. Chain Restaurant Airline Discount Department Store
Portfolio Stress Testing
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What do you think will happen to these stocks if the price of oil suddenly rises ~60%? Telephone/Communications Company +6.4% International Beverage Company -11.6% Housing Developer +5.5% Airline +5.2% Online Travel Agency 0.0% International Oil Company -36.4% Online Auction Service +0.2% Discount Department Store +4.7% Movie Rental Service -38.2% Chain Restaurant +11.2%
Analyzing the impact of macro events
What happens if the price of gold suddenly falls ~40%? Health Insurance Co. Search Engine Auto Parts Distributor Toy Co. Hotel Chain Oil Co. Commercial Bank Online Retailer Mining Co. Discount Department Store
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Portfolio Stress Testing
Stress testing allows deeper understanding of portfolio risks
Uncovers full exposure to changing variable • May highlight unexpected relationships • Allows investment manager to change positioning to alter exposure • May indicate need to hedge against certain outcomes
Allows understanding of implications over a range of variables • Able to test multiple scenarios • Allows investment manager to see changes over time
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Working with your advisor to create a plan
Managing risk
Risk Management IS NOT avoiding risk.
Risk Management IS understanding risk and planning for it.
“The first step in the risk management process is to acknowledge the reality of risk. Denial is a common tactic that
substitutes deliberate ignorance for thoughtful planning.” – Charles Tremper (Risk Management Author)
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Understanding your advisor’s view of risk
Do they think of risk as: Volatility? (e.g., standard deviation)
Probability of loss? (e.g., downside deviation)
An appropriate portfolio? Beta? Batting average? Tracking error? Downside capture?
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Is risk tolerance enough?
Risk Tolerance – the risk normally chosen by you
Perceived Risk – your perception of
the risk involved Required Risk – the risk associated
with the return necessary to achieve your goals
Risk Capacity – the risk you can
afford to take
Willingness to take risk
Ability to take risk
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20-Year Annualized Returns by Asset Class
9.2% 8.4%
2.3% 3.1%
6.6% 5.7% 5.7%
2.5%
0%
2%
4%
6%
8%
10%
S&P 500 Oil Inflation Homes Gold EAFE Bonds Avg. InvestorSources: BlackRock; Bloomberg; Informa Investment Solutions; Dalbar. It is not possible to directly invest in an index. Indexes used are as follows: Oil: NYMEX Light Sweet Crude Future Index. Contract size is 1,000 barrels with a contract price quoted in US Dollars and Cents per barrel. Delivery dates take place every month of the year. Gold: change in the spot price of gold in USD per ounce. Homes: Existing One Family Home Sales Median Price Index. Stocks: S&P 500 Index, an unmanaged index that consists of the common stocks of 500 large-capitalization companies, within various industrial sectors, most of which are listed on the New York Stock Exchange. Bonds: Barclays US Aggregate Bond Index, an unmanaged market-weighted index that consists of investment-grade corporate bonds (rated BBB or better), mortgages and US Treasury and government agency issues with at least 1 year to maturity. EAFE: MSCI EAFE Index, a broad-based measure of international stock performance. Inflation: Consumer Price Index. Average Investor is represented by Dalbar’s average asset allocation investor return, which utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior. Returns are annualized (and total return where applicable) and represent the 20-year period ending 12/31/13 to match Dalbar’s most recent analysis.
Perceived risk is key element to understand
• Perceived risk drives investor behavior • Risk perceived by advisors may differ from risk you perceive
Scared investors flee the market
S&P 500 Index Performance vs. 12-Month Equity Mutual Fund Flows
$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
-$150
-$100
-$50
$0
$50
$100
$150
$200
$250
$300
$350
$400
12/00 12/02 12/04 12/06 12/08 12/10
Net Equity Mutual Fund Flows (billions) Growth of $10,000 in S&P 500 Index
Sources: Informa Investment Solutions; DB US Equity Strategy; Investment Company Institute (US mutual funds and ETFs). Past performance does not guarantee or indicate future results. It is not possible to invest directly in an index.
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Risk management should be incorporated into all financial plans
Financial Plan
Return and Risk Objectives
Required/Desired Return
Ability/Willingness to Take on Risk
Constraints
Liquidity Needs Time Horizon
Taxes Legal and Regulatory Issues
Unique Circumstances
Opportunity to Manage Risk
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Putting a risk management plan in place
Two key objectives of successful risk management plans Incorporate risk sources you or your advisor are concerned about
Defend Against Disaster Manage Ongoing Risks
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Reconciling views on risk
You Your
Financial Advisor
Come to an understanding on how you and your advisor view risk Discuss what risks are most important and how to address Incorporate risk management into overall financial plan
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Important Notes
This material is provided for educational purposes only and does not constitute investment advice. The information contained herein is based on current tax laws, which may change in the future. BlackRock cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. The information provided in these materials does not constitute any legal, tax or accounting advice. Please consult with a qualified professional for this type of advice.
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