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In Focus #70: June 9, 2009


Financial Advisers in Motion; A Primer On the Employment Issues Facing Those in Transition


Retirement Income: Repairing the Damage to Assure the Flow


Train Wrecks of Estate Planning


A Complex Game: The Life Settlement Process
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Assessing and Hedging Risk; A Financial Adviser's Duty


nvesting is risky - if investors didn't know that before, they know it now. But investors may not know that risk, in a particular investment and in an overall portfolio, can be assessed and can be hedged. Financial advisers have a duty to monitor, assess and hedge the risk in particular investments and in overall portfolios, depending upon the investment objectives of the investor.

First, let's examine risk. Though investment risk arises from a variety of sources, analysts use two categories: systematic risk and unsystematic risk. Systematic risk relates to risks that affect all investments, such as the market risk, inflation risk and interest rate risk. By comparison, unsystematic risk relates to individual events that affect a particular investment, such as the business risk and financial risk associated with the company. The critical distinction between the two risks (systematic and unsystematic risk) is that one, unsystematic risk, can be hedged. The other, systematic risk, cannot be hedged, short of staying out of the market.

Likewise, an overall portfolio of individual investments has risk. Financial advisers have a duty to assess that risk, and to hedge against it.

What must advisers do to monitor and assess risk? They have several responsibilities, including:
Analysis of the equities markets;
Use of market indexes and averages in market analysis;
Consideration of principal theories of equity market behavior, including technical analysis and fundamental analysis;
Explanation of news about a company's financial outlook and how it may affect the price of the stock;
Routine review to verify that investments are suitable in view of the investor's investment objectives (safety, growth, speculation and so forth); and
Keeping the customer informed about his or her investments.
Additionally, advisers need to be familiar with the performance measurements known as alpha, beta, R-squared and standard deviation. Beta is a measure of an investment's market risk as measured against a market index. Thus, a beta or 1.10 means that a stock is expected to do 10% better than the market in an up market, and 10% worse than the market in a down market.

Alpha is a measure of an investment's actual historic returns versus its expected performance as measured by beta.

R-squared measures the percentage of the movements in a particular investment that are attributable to movements in its benchmark index. For example, an index fund should have an R-squared close to 100 (or 100%).

Standard deviation measures the range of an investment's performance and is an indication of the volatility of a particular investment. A high standard deviation means the range of performance is very wide, and indicates greater volatility.

Advisers employ numerous methods to hedge risk. As a basic risk management technique, one important strategy is diversification. Portfolios can - and should - be diversified in many ways, such as asset allocation between investment types (stocks, bonds, money market accounts, for example), the particular industry (such as technology, consumer goods, and so forth), companies within a particular industry, geography and investment rating.

As an illustration, consider two types of investment portfolios - aggressive and defensive. An aggressive risk portfolio would have some or all of the following characteristics:
High percentage of the portfolio in stocks;
Stocks concentrated in particular industries, especially those known for volatility, such as technology;
Stocks with high betas and high standard deviation
Additional characteristics of an aggressive portfolio would be use of margin to purchase investments as well as some put and call strategies.

On the other hand, a defensive investment portfolio would have some or all of these characteristics:

A high percentage of the portfolio in bonds and money market account;
A diversified stock portfolio, including the selection of stocks likely to fare well in recessionary times, such as energy, food and pharmaceuticals;
Stocks with low betas and low standard deviation; and
The absence of margin and the absence of option strategies with the possible exception of some covered calls sold and puts purchased.
Financial advisers have duties to assess and hedge risk. Make sure your adviser knows that.

______________________________________________________________________
James J. Eccleston is a securities attorney, representing investors as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He is a past co-chair of the Chicago Bar Association's Securities Law Committee, a past chair of its Financial and Investment Services Committee, a registered investment advisor and a licensed securities principal of the National Association of Securities Dealers (NASD). He can be reached at 312-641-2929.





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