Securities Regulator Provides Guidance As To Managing Investment Risk

By James Eccleston

INRA (the Financial Industry Regulatory Authority) recently published, "Managing Investment Risk" as guidance for investors. It contains helpful advice. Let's overview the key advice contained in the publication.

The publication begins with the simple notion that all investors, except those needing short term funds, need to take at least some risk in order to earn a return that will provide some protection against inflation. With that notion in mind, FINRA proceeds to discuss the types of investment risks that investors face.

There are two general types of investment risk: systematic risk and nonsystematic risk. Systematic risk also is known as market risk and relates to factors that affect the overall economy or the securities markets. In this category risks include interest-rate risk for bonds, inflation risk, currency risk, liquidity risk and sociopolitical risks. FINRA emphasizes, as discussed in detail below, that the best defense against this kind of risk is asset allocation: "This generally involves investing in both stocks and bonds or the funds that own them, always holding some of each."

The other general type of investment risk is known as nonsystematic risk. This kind of risk affects a much smaller number of companies or investments, and is associated with a particular product, company or industry sector. Examples include management or company risk associated with a particular stock, as well as credit risk associated with a particular bond. FINRA emphasizes, as discussed in detail below, that the best defense against this kind of risk is diversification of one's portfolio holdings within each asset class.

Now that we know the two general types of investment risks, how do we assess risk? FINRA sets forth three basic steps for assessing risks. The steps are: (1) Determining the Risk of an Asset Class; (2) Selecting Risk; and (3) Evaluating Specific Investments. Let's review each.

Step 1 - determining the risk of an asset class - contains a basic discussion of the risks of investing in stocks and bonds. The section also briefly discusses cash (and the risk to it posed by inflation), as well as real estate, annuities and mutual funds.

Step 2 - selecting risk - asks the tough question: what level of risk should an investor choose? FINRA states that the answer largely depends upon the investor's age, goals and time frame for meeting them, financial responsibilities, and other financial resources. FINRA also gives a special word of caution for investors who are close to retirement: "As you get closer to retirement, managing investment risk generally means moving at least some of your assets out of more volatile stock and stock funds into income-producing equities and bonds."

Step 3 - evaluating specific investments - addresses the kind of research that investors can perform to evaluate risk. FINRA details the kinds of company documents available through the Securities and Exchange Commission. Likewise, there is a discussion of rating services, with the much-deserved caveat not to rely on ratings until one knows their "methodologies and criteria."

Putting it all together, FINRA discusses "Investing to Minimize Risk." The key takeaway: consider asset allocation and diversification if interested in minimizing risk while realizing a satisfactory return. FINRA endorses asset allocation as "a useful tool in managing systematic risk because different categories of investments respond to changing economic and political conditions in different ways." Continuing further, FINRA states, "By including different asset classes in your portfolio, you increase the probability that some of your investments will provide satisfactory returns even if others are flat or losing value." Importantly, it is important to have "money in multiple asset classes at all times", because, "[w]hile you can recognize historical patterns that seem to indicate a strong period for a particular asset class or classes, the length and intensity of these cyclical patterns are not predictable." FINRA reports that financial services companies make adjustments to their recommended asset allocation mix on a regular basis, and that doing so for investors is not the same thing as the discouraged practice of market timing.

Similarly, FINRA endorses diversification in order to minimize investment risk. The publication states, "Diversification, with its emphasis on variety, allows you to manage non-systematic risk by tapping into the potential strength of different subclasses, which, like the larger asset classes, tend to do better in some periods than in others." In other words, sometimes small company stocks outperform large company stocks, and vice versa. Likewise, FINRA outlines two strategies to diversify bond investments: the barbell strategy (buying roughly an equal amount of short-term and long-term bonds) and the laddering strategy (buying bonds with the same term but with different maturity dates).

With both asset allocation and diversification, FINRA urges investors to "stay actively attuned to the results", and to be prepared to "make adjustments when the situation calls for it."

In conclusion, the FINRA publication provides helpful and timely advice for investors (and their advisers). After all, prudent investing is not just about return, it's about managing investment risk!

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About the Author: James J. Eccleston leads the Securities group at the Chicago law firm of Shaheen, Novoselsky, Staat, Filipowski & Eccleston, P.C., where he represents investors in recovering investment losses and financial services professionals in disciplinary, employment, and compliance matters. He has held numerous securities licenses and Chicago Bar Association leadership positions and serves as an arbitrator and mediator. He is a recipient of Martindale-Hubbell's highest rating (AV) for legal ability and ethics, and is named to the Illinois Super Lawyer and Leading Lawyer lists.
JEccleston@snsfe-law.com, 312.621.4400, www.snsfe-law.com, www.financialcounsel.com.