An individual's acceptance to risk is ascertained by a complete review of their investment history coupled with an in-depth analysis of personal issues such as age, income, marital status, number and age of children, educational background , retirement outlook, pension plans, health, anticipated actuarial lifetime, the client's goals and objectives and a myriad of other items.
Much of this is covered under the areas of suitability but I do wish to reiterate that a broker should NEVER take a client's goals and objectives too literally or that they represent Carte Blanche authority to commence the objectives the client supposedly desire. Many consumers have absolutely NO idea what they SHOULD be doing- and this may be diametrically opposed to what they would like to do.
But assuming a broker/adviser can define a level of risk acceptance for the
particular investor, it is equally necessary that the broker know what types
or groupings of investments match the risk agreed upon. This is not an esoteric
exercise at this point. It is a knowledge and understanding of historical
volatility of an investment sub group coupled with a grasp of fundamental
statistics. The following basic definitions are required.
Interest Rate: Also called money rate, capital value and income risk Variations in the value of bonds (primarily) due to the general movement of interest rates in the economy. As interest rates move up, bond prices fall. Longer term bonds are more greatly effected than shorter term bonds.
Percent Change in the Price of a Par Bond paying 8.5%
Stated Maturity 2% rise in rates 2% decrease in rates
Short term (2.5 years) -4% +5%
Intermediate term (10 years) -12% +15%
Long Term (20 years) -17% +22%
Inflationary risk: As inflation may rise over a period of time, the constant
value of a bond's dividends or a CD's fixed yield are lessened. By the same
token and as has been evident during the 1908's and early 1990's, a lowering
of inflation and interest rates causes the value of future payments to maintain
a greater value of purchasing power. The greatest risk would exist in government
bonds, savings deposits, fixed annuities and any fixed income investment.
Default Risk: Also known as financial, business, functional and credit risk. The risk that a corporation or municipality will default on its payments in the future. The longer the term to repayment of principal, the greater the risk. A general gauge to this risk are the ratings from the major services such as A.M. Best, S&P, Moody's and Duff's and Phelps though there are several others that are viable.
Callable Risk: Also known as prepayment risk. A major issue for most bond investors since at least the mid 1980's. It is the right for a corporation or municipality (even the U.S. Government on a few issues) to call the bond due and pay off the principal prior to the stated final maturity of the bond. The corporations and municipalities would call a bond due to an overall reduction
of interest rates in the economy to the point. For example, if a municipality issued a bond in 1985 at 9% and current rates were 6%, it would be financially worthwhile to pay of the old bonds and re-issue new bonds for the savings of 3% per year. Many bonds have a form of call protection where they may not be called for a certain number of years. Such bonds may also pay a premium if called- though such premium may be small. This risk is tied directly to Risk of Reinvestment below.
Psychological risk: Also known as social risk. This is the risk that an investor will act emotionally instead of logically in reflecting on current waves of great optimism or pessimism that periodically sweep the investment market, or current moods to individual stocks or certain mutual fund groups.
Risk of Reinvestment: When the returns from an investment are reinvested in current investments potentially at significantly lower rates. The most notable problem is with maturing and callable bonds. For example, corporate and municipal securities purchased in the early 80's yielded rates as high as 15%+. As these bonds matured, investors have to reinvest at much lower rates- assuming they accept the same risk- or increase their risk substantially in order to generate the same return. Callable bonds also cause the problem since they would only be called away from the investor if rates in the economy were falling. Other investments also cause the same problem but are not so clearly identified to investors. The most notable of these are GNMA funds or individual issues. Each return encompasses part of principal which, for most individuals, would need to be reinvested.
Market Risk- the risk and investor accepts that should the market move down, so might the securities he holds. May be tempered by the use of securities that have a cross correlation with the market.
Liquidity- The ability to turn an investment into cash in a short time. Unlike most stocks which have a liquid market for even one share, small amounts of bonds are subject to price concessions for size. The size suggested by various texts for bonds ranges from $100,000 to $500,000.
Remember that it is also necessary to diversify with bonds so a number of issues must be purchased. The questions that arbitrators must acknowledge is, was the investor aware of the change in value of the bonds if held to less than maturity; was the investor aware of the potential discount on the bond holdings if he/she needed to sell quickly and was the investor aware of the risk of diversification if less than 10 bonds were purchased.
Beyond these initial definitions are the statistical concepts of volatility underlying the use of particular investments- primarily stock issues, though bond volatility is a factor due to considerable movement since the early 1980's.
Standard Deviation: By absolute definition, it is the square root of the variation of a number of events. The best way to measure total risk for a security or group of securities is to calculate the variability of return over time using standard deviation. (Dynamic Asset Allocation, 1991, David Hammer, page 43) The higher the standard deviation, the greater the risk overall. For stock or bond markets, the standard deviation of return- assuming a large sampling which most of these markets provide- would be the maximum amount of variability that occurs 68% of the time.
The use of standard deviation helps to provide the framework for the expected return of a group of assets- more extensively defined under the section on asset allocation. But a basic example shows the mathematical probability of a particular portfolio's return given historical averages or expected returns.
Expected return Standard Deviation
1926- 1987 1926 -1987
U.S. Common Stocks 10.0% 21%
Small Cap Stocks 12.1% 35.9%
Long Term Corporate 4.9% 8.5%
Long Term US Bonds 4.3% 8.5%
Intermediate US Bonds 4.8% 5.5%
Treasury Bills 3.5% 3.4%
Inflation 3.0% 4.8%
A simple portfolio could be constructed of the three basic groups of stocks, bonds and treasury bills. An aggressive portfolio would have a greater percentage of stocks and a more conservative portfolio would have a greater percentage in treasury instruments.
Aggressive Portfolio Mix Expected Portfolio Mix Standard Std Dev
Return Return Deviation Port Mix
Stocks 60% 10% 6.0% 21% 12.6%
Long Term US Bonds 25% 4.3% 1.08 8.5 2.12%
Treasury Bills 15% 3.5% 0.53% 3.4% 0.51%
Total expected return 7.61% +- 15.23
The expected return over time is 7.61% but with the standard deviation for this portfolio at 15.23%, short term results 68% of the time would be from a negative -7.62% to a positive 22.84%
A less aggressive portfolio might consist of
Conservative Portfolio Mix Expected Portfolio Mix Standard Std Dev
Return Return Deviation Port Mix
Stocks 25% 10% 2.5% 21% 5.25%
Long Term US Bonds 60% 4.3% 2.58% 8.5 5.1%
Treasury bills 15% 3.5% 0.53% 3.4% 0.51%
Total Expected Return 5.61% 10.86%
As one would expect, the expected return would be less since fewer stocks
are within the portfolio and over time would be 5.61%. By the same token,
the volatility of the portfolio would be considerably less at 10.85%. This
would mean that a short term result could be a negative return of 5.25% to
a high of 16.47%.
While this conservative movement may appeal to the novice investor unwilling
to take much risk, the overall return after taxes (say 35%) reduces the return
to just 3.64%. When inflation is factored into the return at 3%, the return
to the investor is minuscule.
NOTE: The deviations above are based on just one year and reflect the volatility
an investor must accept over short time frames. As time progresses however,
the standard deviation for a given time period is determined by multiplying
the expected return by the square root of the years in question. Therefore,
when a 10 year period is assumed, the standard deviation for bonds drops
to about 2% overall and for stocks about 3%. Patience is rewarded- assuming
one has the right stock or fund to begin with. This however, is not always
a valid assumption.
There is a particular caveat to the aspect of time diversification- and that
is irrespective of the amount of time involved, a serious loss- one standard
deviation- in a given time frame can seriously erode the final projected
return. Assume an annual rate of return of 12%, a time frame of 5 years and
a standard deviation of 20%. The standard deviation for 5 years would equal
20/square root of 5 or 8.94%. But a movement of that standard deviation over
five years means that the ultimate return is estimated by (1- .0894)5th or
62.6% of projected value. Or essentially a 40% reduction of funds that what
This means that uncertainty compounds over a greater number of years. "Ultimately this latter effect dominates in the sense that the total return becomes more uncertain the longer the investment horizon" and "this is analogous to an insurer taking on more insurance policies. The fact that these policies are independent of each other does not offset the effect of placing more funds at risk. Focus on the standard deviation of the rate of return should never obscure the more proper emphasis on the possible dollar value of a portfolio strategy." (Investments by Bodie, Kane and Marcus, Irwin, 1989).