How to manage risk in a client's portfolio

How does risk impact asset allocation? 

The beauty of financial markets, much like the Olympics, is that there really is something for everyone. 

There are ‘set and forget’ investors favouring diversified multi-asset portfolios, and highly leveraged day traders ‘playing the markets’ and everything in between. 

Advisers most likely would, and indeed should, question whether leveraged day trading is true investing as opposed to pure speculation, but the point is that financial markets can deliver wherever one sits on the risk spectrum. 

While the past is no predictor of the future, it is a very powerful indicator of what sort of returns and what sort of risk you should expect from various asset classes. The asset class universe can be divided into three main building blocks. 

1. Low-risk liquid assets: These include government bonds, high-quality corporate bonds and cash. These assets provide greater capital security than other assets and are therefore considered to be less risky, but the returns will be lower. 
2. Higher-risk liquid assets: These include equities and lower-grade corporate bonds, private equity funds, industrial commodities and hedge funds. These assets have a track record of delivering higher long-term returns, but they do carry more risk. 
3. Diversification assets: Balancing the two components above, diversification assets act as a stabiliser in times of market stress and can include commodities, precious metals, property and other assets negatively correlated to equities and bonds. 

The individual’s risk profile will determine the proportion of each of these three components that will make up their portfolio. For example, someone wanting to secure capital growth may go for a portfolio of 85 per cent in equities, 10 per cent in alternatives and 5 per cent in cash and fixed interest. 

Someone wanting a more balanced portfolio may go for 70 per cent in equities, 20 per cent in cash and fixed interest and 10 per cent in alternatives. On the other end of the scale, someone taking a more conservative position may go for 40 per cent equities, 40 per cent in cash and fixed income and 20 per cent in alternatives. 

How can an adviser manage risk? 

Managing risk is not about avoiding any falls in the value of a client’s portfolio. While this would be nice, the sun will not be shining every day so this should not be the objective of risk management. The objective should be to avoid any sustained reduction in value by selecting an efficient and well-diversified allocation of assets. 

Using the three building blocks outlined above will ensure asset class diversification, but there are a number of other ways to manage risk. First and foremost is to spread the asset allocation across various regions and markets. 

While the world is increasingly connected and vulnerable to similar risks (just look at the pandemic), there is still value in selected assets in a range of countries and regions to reduce the risk of one poorly performing market or region. This does, however, open the door to currency risk, which is the risk that exchange rate movements will go against your client and reduce the return they receive from overseas assets.