Protect yourself
How to guard against your adviser going rogue with risk.
There’s no doubt investing can be very overwhelming at times, particularly since most people don’t know where to start and, as a result, end up diving head first into the market without knowing just how deep the water is first.
This is where a good adviser or investment manager should be able to help. That said, until a uniform fiduciary duty is imposed on all advisers, a simple know-your-client form will likely be insufficient to help create and monitor a properly functioning portfolio.
Since a fiduciary duty for retail advisers is likely years away, if at all, we recommend that all investors create their own formal investment policy statement (IPS) that outlines their overall risk tolerance and sets the rules around how their portfolio should be invested.
At the very least, it will provide some protection if your adviser goes offside.
The first step in formulating an IPS is to do a full risk assessment that includes determining your overall willingness to take on risk as well as your ability to bear it.
Your willingness to take risks is decided by a number of factors, often emotional in nature, such as personality type, outlook and inclination for independent thinking.
It can also be shaped by your past experiences such as having previously lost money, how you earned your wealth, and even how you currently live your life. Your ability to bear risk, on the other hand, can vary greatly from your willingness, but you should be able to bear more risk if you have a longer investing horizon, a higher level of income and a larger net worth.
Once the risk parameters have been defined, the next step is to match your risk tolerance to the proper portfolio asset mix.
For example, a portfolio balanced between capital growth and income — a 60-per-cent weighting to equities and a 40-per-cent weighting to bonds — makes sense for those with a medium willingness and ability to take on risk.
The third and final step is to determine some realistic return objectives, which may be targeted on an absolute or a relative basis.
An absolute objective is setting a target rate of return either in nominal or real (inflation-adjusted) terms that is separate from the market and/or what others are doing. Alternatively, returns can be stated on a relative basis, such as a particular benchmark like an equity market index.
Our preference is an absolute return since we find that managers and regular investors alike tend to take excessive risk in order to try to beat a se- lected benchmark. Additionally, there are all kinds of studies showing that few managers are consistently able to outperform passive benchmarks.
Setting an independent return also allows the manager and/or investor to focus on mitigating the level of risk the portfolio is taking on at the same time.
Most importantly, the return objective must be realistic, meaning it is consistent with your risk tolerance and also with the current economic and market environment.
For example, 15-per-cent nominal returns might be possible when inflation is 10 per cent, but will be unlikely when inflation is only two per cent.
Keep in mind that today’s investment environment is characterized by equity markets trading near record-high valuations and bond yields near record lows. Also remember that past performance is not indicative of future performance.
Finally, we recommend reviewing your IPS at least once a year to look for any discrepancies between the portfolio’s actual formulation against the pre-set guidelines. For example, conservative investors with a moderate risk tolerance should not have 80 per cent of their portfolio in equities, nor should preferred shares dominate their fixed-income weighting.
Conservative investors should not be 80% in equities