Proper diversification and effective portfolio management techniques can help control the amount of investment risk a portfolio is exposed to. However, in most cases, some level of risk is necessary in order to meet future cash flow requirements. The second practice of the Formalize step of the Fiduciary Quality Management System is to identify a level of risk for a portfolio that is just enough to meet investment objectives, yet not so much that fiduciaries would be compelled to abandon the investment strategy at exactly the wrong time.
Let's take a look at the Practice itself and the associated criteria:
The balancing act that the fiduciary must perform is to both be comfortable that they have put the portfolio in a position to succeed in meeting it's stated objectives as well as not exposing it to so much risk that it couldn't weather a "large loss" scenario if things didn't play out as anticipated. Simply stated, a fiduciary has the potential to "fail" by being too conservative or too aggressive. A fiduciary could adopt a "safe" strategy by keeping a portfolio in cash, but then see the portfolio's purchasing power whither under inflation. Or, a fiduciary could adopt a sound, long-term aggressive growth strategy that is abandoned at the first sight of a downturn in the market.
One suggested approach is to "stress test" an investment strategy by analyzing possible investment outcomes (large loss, most likely, and best case) over the next one, three, and five years. The fiduciary should then consider the possible consequences of each outcome:
- Will the investment results enable the fiduciary to cover short- and long-term liabilities and/or objectives?
- Can the fiduciary stomach the "large loss" scenario?
If the answer to either of these questions is "no," then the fiduciary has some decisions to make. They must either adjust the investment strategy until they find one that passes this stress test, or recalibrate objectives to allow a lower risk and return strategy.
To learn more, consult the following resources:
- Complete text of Practice 2.2 from the Prudent Practices for Investment Stewards handbook
- Legal substantiation to Practice 2.2 from ERISA, UPIA, UPMIFA and MPERS
- fi360's Asset Allocation Optimizer, which can calculate the risk, return, and large loss scenarios of a client’s portfolio
- A primer from FINRA on managing investment risk
- FinaMetrica's risk profiling system, an article that profiles their strides in making risk tolerance profiling a more meaningful pursuit, a study using FinaMetrica that measures peoples' behaviors when confronted with investment risk and their own primer on risk profiling (Note: Finametrica is an fi360 partner)
- The Ibbotson® SBBI® Valuation Yearbook for "estimating the cost of capital"
- The online book An Introduction to Investment Theory on calculating risk and return
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The Spotlight on Practices series highlights one of the Prudent Practices for Investment Fiduciaries in order each month. To learn more about the Practices, click "Spotlight on Practices" link in the categories list or visit the Practices page on fi360.com. If you have any questions or comments, leave them in the comments section below each post, or email us at blog@fi360.com.
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