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PORTFOLIO CONSTRUCTION | MODULE 4

Rethinking risk

Continue the portfolio construction course with module 4, which explores how to rethink the impact risk has within investment portfolios, the different types and how it
is measured.

What does risk really mean?
In the financial industry, risk is often measured by the standard deviation (or the change) of returns, but it can also be thought of as the probability of an investment resulting in a financial loss.
Risk

All investments carry a degree of risk, yet risk is one of the most misunderstood variables
in investing

Returns are unpredictable but risk is manageable.

While returns are unpredictable, risk is manageable, and is not inherently bad. Instead, focus on ensuring that any risk being taken is intentional.

At a basic level, the higher the potential return on investment, the more risk an investor must take. Establishing a benchmark to measure against will provide insight into whether an investment is too aggressive or too conservative relative to an investor’s goals.

Some of the most common forms of risk

Market risk
Market risk
Market selloffs can occur, which is when the price of investments can plunge because investors try to exit their positions all at once in fear of suffering steeper losses.
Concentration risk
Concentration risk
This happens when investors place too much of their capital in a small number of assets.
Credit risk
Credit risk
This assesses the probability of a borrower repaying their debt.

Good risk management means looking beyond the allocation of assets and considering the types of stocks and bonds that go into a portfolio

Look beyond the surface to see what types of investments make up a portfolio.

Financial professionals should know what bonds would diversify the types of shares a client owns.

For example, high-yield bonds can often move in the same direction as equities in times of stress and are thus an unreliable hedge against stock market volatility. Likewise, interest rate decisions do not just impact bonds; some equity sectors can take divergent paths based on underlying rate moves.

However, there are no hard and fast rules when it comes to finding the right level of risk. In addition to understanding their clients, advisors should have a sophisticated strategy in place for managing risk.

How much risk should a portfolio
take on?

This depends on an investor’s level of risk appetite and creating a portfolio that weighs current market returns with the potential for future risk. To best serve investors, financial professionals should:
Client profile
Understand their clients’ risk tolerance
Grasp what risk means to their clients and map out exactly how much risk they could potentially endure.
Map
Map the types of risk
accordingly
Assess what types of risk would match that level of tolerance.

One thing to keep in mind is that financial professionals’ clients’ level of tolerance may change with shifts in the market, often becoming more risk averse during market volatility and more less so when the markets are favorable. The key is to build a portfolio that can achieve an investor’s financial goals within the bounds of volatility they can stomach.

Risk management techniques

1. Diversify

Ensuring a portfolio is well diversified by investing across a range of asset classes, industries and geographies should be the foundation of any risk management strategy.

2. Understand client outcomes

Financial professionals should understand how each investment fits into their clients’ portfolios, what could cause it to rise or fall in value, and how it meets their clients’ overall investment objectives. This essentially means carrying out a rigorous due diligence process when selecting potential investments, as outlined in the investing and monitoring module of this course.

3. Use a holdings-based analysis

Financial professionals with access to statistical, computer-based models can take a risk-first approach by using a holdings-based analysis to assess risk. This type of analysis examines the underlying securities of a portfolio and looks at its current holdings, rather than its past returns. Combining a holdings-based approach with other returns-based strategies allows advisors to better understand total portfolio risk and whether it is likely to stay within a client’s level of risk tolerance.

Think differently

Advisors shouldn’t try to avoid risk, but prepare for it and know what to do when there’s a downturn in the markets. Understanding the levels of and different kinds of risks can help develop successful portfolios. By leveraging BlackRock’s reports and insights, advisors can develop a disciplined approach to risk management and portfolio construction. Using these insights will allow for smarter investment decisions that will match their clients’ appetite for risk.

This concludes the fourth module of the portfolio construction course. Read the next module, which discusses the benefits of diversifying investments across multiple factors and the relationship to risk, to continue the course.