HOFFMAN,
WHITE & KAELBER FINANCIAL SERVICES, LLC
Investment
managers & WEALTH Advisors
This is the March 2007 monthly Wealth Management newsletter
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The Game of Risk
Have you
ever heard of the game RISK?
RISK is probably the best known and most
played war game. The game was first
released in
The roll of
the dice means a lot in the game of RISK, but so do strategy and
intelligent tactical decisions. Winning
involves a bit more than knowing the rules.
Strategic thinking is required as, with each turn, you are required to
make decisions about how you will launch daring attacks, defend your territory
and move across continents with your plan to take over the world. Every decision made is subject to immediate
or future risk. The game ends when there
is only one player remaining.
Have you
ever played it? What kind of player were
you? Did you like to start off
aggressively and march right into battle?
Did you like to form alliances with other players and share risks? Or, were you the type of player that studied
the game’s most probable winning strategies to tilt the odds in your favor?
What kind
of investor are you? Do you ponder risk that
you’ll be subject to when you decide whether or not to invest? Do you study the most probable winning
strategies to tilt the odds in your favor?
If you answered “yes” to the last question, you may be among a
successful minority of investor types.
When we
invest or don’t invest, it is our turn to roll the dice in the financial game
of RISK; it requires committing to a decision before the eventual outcome
is known. Therefore, the decisions
we make should be guided by a strategy for how we will launch our daring attacks,
defend against losses and earn enough to enjoy the world in our own fashion. Yet, it is hard to formulate a strategy when
you don’t fully understand the rules of the game. It is also hard to distinguish a good investment
strategy from
a bad one without considering the risks.
At Hoffman,
White, & Kaelber Financial Services, LLC, we are committed to providing our
investors and our readers with every advantage when trying to preserve and grow
their wealth. We seek to empower you
with the results of careful, deliberate and rigorous thinking.
In this
newsletter we will provide you an introduction to some basic types of investment
risks and briefly suggest how they factor into your decision making and investing
strategy. If you are looking for
information and ideas to help you achieve better long-term results with your
investments, we think you’ll get a great deal from this newsletter. Then, be sure to look over our market comment
and performance data at the end. And, our web site recently received a
long-needed “make-over”, so please take a look.
Investment Risk – Course 101
As investors
ponder the possible outcomes of their decisions, behavioral scientists believe
that we don’t often think enough about risk, which we shall define as the
possibility of an undesirable result. Well stated by Sir John Krebs, a former medical
research professor at
If true,
maybe this is due to lack of understanding, impatience or the over-whelming or dampening
emotional effect of considering risk. So,
before we delve into understanding some basic types of risk, let’s consider
some basic premises of how we make decisions:
In Dr. Tom
Spradlin’s “Lexicon of Decision-Making”, found on Duke’s
In the
world of investing, the probability of consistently achieving positive results
should not be left to luck. When one
gains confidence based upon past luck, your decisions could certainly lead to
an outcome of poverty when risks are not considered in the equation.
It should
also be considered that risk is unavoidable.
This seems best articulated in Wikipedia.org’s introduction to
investment risk: “On ground of assurance
of the return, there are two kinds of investments – Risk-less and Risky. “Risk-less” investments are guaranteed, but
since the value of a guarantee is only as good as the guarantor, those backed
by the full faith and confidence of a large stable government are the only ones
considered "risk-less." Even
in that case the risk of devaluation of the currency (inflation) is a form of
risk appropriately called "inflation risk." Therefore no venture can be said to be by
definition "risk free" - merely very close to it where the guarantor
is a stable government.”
In the
investment world, the game is fraught with a great many risks to consider. In fact, there are so many that you may easily
be overwhelmed by the number of them and the pursuit of identifying each and
every one prior to making a decision is a daunting task. But that doesn’t mean that they should be
ignored. So let’s begin to discuss a
framework for understanding them.
It is
believed that all risk can be categorized into one of two “buckets” – either it
can be classified as “systematic” risk or “un-systematic” risk. I know that these terms can seem quite
technical and I’ll do my best to simplify their meanings for you.
Systematic
risk should be considered as any type of risk that is influenced by broad
factors. While the word “systematic” may
conjure up the thought of processes that are executed by following a logical
and methodical series of events, I want you to focus more on the word
“system”. Think of these types of risks
as being dependent upon or as being influenced by being part of a bigger
group. Call it risk by association.
As an
example, let’s consider “market risk”.
If the stock market suffers a downward correction, like it did last
week, you may have seen your particular investments dragged down by the
“market”. When we look further into
types of market risk, they can be broken down into smaller segments of
systematic risk. They could be
geographically related, industry related or even, grouped by company size.
On the
other hand, un-systematic risk should be considered as any risk that is unique or
specific to a particular situation. These
are risks whose outcomes are not particularly related to or shared by a broad
group. In the investment arena, the two
most common sources of these specific types of risk are business risk or
financial risk. Business risk
would relate to any number of situations where a single or multiple events could
occur that would hinder the operations of a company; and, financial risk
relates to the possibility that a company will not have adequate cash flow to
meet its debt service obligations or to meet operating expenses.
Now, let’s
identify a few types of investment risk and test yourself to see how you would
classify them.
Basic Investment Risks
When we
begin to identify investment risks, try and think of how a tree forms: The primary stem of the tree forms the tree
trunk – let’s call this all risk. Then,
offshoots from the trunk will form into the initial broad branches – let’s call
these “systematic” risk limbs. Then,
each of these broad branches will form smaller limbs that will blossom leaves –
let’s call the smallest limbs and leaves “un-systematic” risk twigs and leaves.
In terms of
gauging the impact of risk types in your decision-making, you should begin to understand
that as you go further “out on a limb” or higher “up the tree”, the more severe
the impact may be should you suffer an adverse or bad outcome.
Market
Risk, Business
Risk and Financial Risk have already been described in the section
above, and below are listed some other basic investment risk types (I’ll leave
it to you to determine where they fit on the “risk tree”):
Inflation
Risk – this is also
referred to as “purchasing power risk” and it can impact investors in many
ways. Through the ages, the cost of
purchasing goods and services has risen over time. So, if you keep your money under a mattress
or your investments don’t keep pace with inflation you will lose purchasing
power over time. And, inflation has also
been known to impact market risk, interest rate risk, political risk, currency
risk, etc.
Liquidity
Risk – has to do
with how readily you can buy or sell an investment or a personal use
asset. With investing, it is important
to remember that an asset is only as valuable as the next person would pay you
for it. If you readily need to sell an
illiquid asset and nobody wants to trade with you, you may have to liquidate at
a much lower price than expected in the market place. Liquidity risk can also compound other risks
when a company, or a country or a financial market experiences a liquidity
crisis.
Credit
Risk – this is the
same as “financial risk” explained above.
Interest
Rate Risk – this is
the risk that the relative value of a loan made between a borrower and a lender
will worsen due to a change in the market rate for loans of that type – whether
those loans represent government bonds, corporate bonds or a loan between a
banker and an individual. The market for
interest rates can be impacted by a government’s monetary policy and or by
inflation risk or other factors.
Currency
Risk – also known
as “foreign exchange risk”, this is a type of “market risk” that can adversely
impact the purchasing power of goods, services and investment between parties
in one country trading with parties in another country. For investors, it can reverse or enhance returns
earned on investments; and, for consumers, it can adversely impact the cost of
purchases. A weaker currency can make
imported goods and services more costly and, at the same time, make exporting
goods and services more attractive.
Political
Risk – this can
also be referred to as “legal risk” or “regulatory risk”. When a government, or a governmental agency,
makes changes in its political structure or policies, the impact can trigger a
whole slew of other risks – certainly every one of those described above.
Active
Risk – this refers
to the risk in an investment portfolio that would be attributable to the
decisions made by the portfolio manager and is exclusive of any market risk. Active portfolio management is simply an
attempt to beat the market as measured by a particular benchmark like the
S&P500; whereas, passive management is more commonly called indexing. Active risk has more to do with how well an
active manager may or may not perform relative to his or her index benchmark
from both a risk (volatility) and return perspective.
Asset
Allocation Risk –
as opposed to active risk, this risk relates more to the adequacy of, or lack
thereof, an investment portfolio’s diversification among different asset
classes (or “index benchmarks”). Poorly
managed asset allocation risk occurs when a portfolio manager allows a particular
market risk to be over-concentrated due to undisciplined risk-taking or through
ignorance of over-lapping positions.
Asset allocation risk can sometimes be unavoidable when two or more
markets, asset classes or index benchmarks – that are generally driven by
dissimilar factors – begin to act similarly.
What Kind of Investor Are You?
When we
started this letter, we discussed the board game called RISK and how
winning at that game required more than just knowing the rules. We discussed how strategic thinking is
required and that every decision made is subject to immediate and future
risk. The same is true for investing.
As stated
earlier in this article, in the world of investing, the probability of
consistently achieving positive results should not be left to luck. When one gains confidence based upon past
luck, your decisions made could certainly lead to an outcome of poverty when
risks are not considered in the equation.
As with RISK, where the roll of the dice means a lot, luck plays
a role in the investment process. Yet,
it is strategic thinking and intelligent decisions that help you win at
both the game and when investing.
At HWK
Financial, we take a prudently targeted risk approach to investing. Our clients desire having a reliably stable
source of invested funds for their current or future spending goals and needs;
they want their invested funds to keep pace with inflation; and, within
reasonable bounds of risk-taking, they want to see their invested funds grow
beyond their expected spending goals and needs plus inflation.
Our
Individually Managed Account program represents a broadly diversified
investment strategy designed to offer institutions, individuals, families or
groups a risk managed approach that maximizes the benefits of investing in both
traditional and non-traditional investment opportunities.
Hoffman, White & Kaelber Financial Services Investment
Performance Update
Much of February started with a continued rally in the
markets, right up until the last two days of the month. On the 27th of February, a market
correction that started in
The correction was reported to have been orchestrated by the
Chinese government, much like when Fed Chairman Bernanke spooked the markets
last summer and past Fed Chairman Greenspan spooked the markets in April of
2004. Each time the markets climbed “the
wall of worry” and recovered to new yearly highs. We see the potential this year to be no
different.
Many governmental policy makers and market pundits
characterize this as a healthy correction where the markets had seemingly
gotten ahead of themselves. It didn’t
help much that the Dow Jones Industrial Average appeared to have dropped by
more than 300 points in roughly 30 seconds time on February 27th at
approximately
For the month ended February 28, 2007, our
one-month performance is down 2.60%, our three-month return is up 1.89%, and
our average annualized return since inception is up 8.61%. Our since inception risk measures edged upwards
slightly, but remain very conservative at +/- 6.12%, and our since
inception Sharpe Ratio (reward for risk taken) remains very respectable at 0.95.
For more
performance information, please see our web site for details.
Want better long-term results from your investments?
Choose Us As Your Investment Manager!
Research us on the web at www.hwkfs.com