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Introduction

In part one of this two-part series titled: How Investors Can Mitigate Their Portfolio Risk In Today's Tumultuous And Volatile World: Part 1, I primarily focused on how risk is thought about and dealt with in today's so-called world of modern finance theory. As I stated in the first article, my objective was not to denigrate what is commonly referred to as MPT (Modern Portfolio Theory). Instead, my goal was to establish how risk is commonly dealt with in the modern world of finance, in order to contrast it against what I coined as "Ancient Portfolio Reality."

This was the concept that I was originally taught and trained to implement, prior to today's ubiquitous implementation and utilization of MPT. Therefore, this article will be dedicated to discussions about building portfolios based on time-tested principles of business, economics and accounting and common sense strategies to mitigate risk. Moreover, this article will discuss how portfolios during the good old days of "Ancient Portfolio Reality" were constructed prior to MPT.

This was a time when portfolio construction was focused on building and designing portfolios based on their ability to meet the specific goals, objectives and risk tolerances of the portfolio beneficiaries. Stated more directly, I was taught that portfolios should be constructed based on simple and straightforward goals and objectives. These would include whether a perspective investor was in need of growth or income or a combination of both.

Moreover, risk tolerances were also given serious consideration. Consequently, we dealt with basic and simple concepts like aggressive, moderate or conservative aspects of growth and income. Asset classifications were also more straightforward. Instead of the numerous asset classes that are promulgated in today's modern world of finance, I was taught the simple asset concepts of investing in debt or equity. These concepts were euphemistically referred to as loaner-ship versus owner-ship. In other words, were you more comfortable loaning your money at interest (fixed income investments) or could you handle a little more risk by taking an ownership position (equities).

The Many Facets of Investment Risk

It is arguable that the most important aspect and challenge that investors face when designing their portfolios is how they handle risk. Moreover, this is especially important for those investors that are either in retirement or close to retiring. These investors are often dependent on the success of their portfolio's ability to provide them a safe and successful retirement.

To make matters worse, the concept of risk is a very complex subject. There is not just one risk that investors must deal with. Instead, investment risk is a multifaceted subject comprised of many different kinds of risks that must be successfully considered and dealt with. However, although the task is challenging and perhaps even daunting at first glance, the proper mitigation of the various kinds of risk is not an insurmountable task. All one truly needs is a little bit of knowledge, tempered with some good old common sense and the willingness to do some basic work. Possessing and implementing these attributes will go a long way towards successfully mitigating most risks, or even eliminating them all together.

Moreover, it is an undeniable principle that the first step toward solving any problem is clearly identifying the problem. Therefore, with this article, I will attempt to list, and define what I believe to be the most important investing risks that investors must face and deal with. Additionally, I will offer brief introductions into what I feel are the most effective ways of dealing with the many faces of investment risk. Of course, the reader should be aware that the best that can be accomplished in one simple article is to provide a brief overview and introduction to investment risk and its management. But every journey starts by taking the initial step.

The Most Prominent Investment Risks

In addition to being a multifaceted concept in the general sense, risk as it relates to designing and building a retirement portfolio is also different in regards to the type of asset under consideration. Although both fixed income and equities share the risk of total or catastrophic loss, there are specific risks to be considered whether you are positioning yourself as a loaner or as an owner.

Moreover, what follows will be a brief description of each type of risk that is most prominent and appropriate to the asset being discussed, followed by a few brief comments on how I believe they can be intelligently mitigated. The reader should also recognize that there are certain risks that are shared by both of the broad asset classes. However, my goal is to address the risks that are most prominently associated with fixed income, and then with equities.

Primary Fixed Income Investments Risks

Interest Rate Risk

Interest Rate Risk
(Click to enlarge)

Stated somewhat over simplistically, all fixed income investments are exposed to interest rate risk. Regardless of the quality of the issuer, future dynamic changes in interest rates will have a similar effect. The effect can be either positive or negative depending on future interest rates.

If investors in fixed income are faced with a rising interest rate environment, they can expect a negative impact (although only temporarily) on the value of their existing or previously issued fixed income instruments. When future interest rates rise, the value of previously issued bonds with lower coupons will proportionately fall in order for their yield to maturity to equate to the newly issued higher rate bonds.

Conversely, if the fixed income investor is faced with the prospects of a falling interest rate environment, they can expect a positive impact (once again, only temporarily) on the value of their existing or previously issued fixed income instruments. In this scenario, the previously issued bonds with higher rates will appreciate so that their yield to maturity equates with the yields available from newly issued instruments.

The reason that I suggest that the impact will only be temporary is because of the maturity feature of fixed income instruments such as bonds, notes, etc. In other words, publicly traded fixed income instruments will ultimately move to par value when they mature; assuming of course, that they don't default. Therefore, any gains or losses will dissipate when the fixed income instruments ultimately mature at par value. This can create a dilemma for the fixed income investor.

On the one hand, they are faced with the decision about whether or not they should harvest any profit that the bond may currently offer them before it matures. On the other hand, they have to consider the current yield that they would receive when they reinvest. Market realities would indicate that the current yields available from newly issued bonds would be lower than the coupon rate of the premium valued bond they would be selling. In my mind, the only way to rationally make that decision is to run the numbers through to their logical conclusion.

If the premium is large enough so that their net income would remain the same because of the larger principal amount that the premium valuation on their existing bonds offers, then the decision might be a practical one. If the premium valuation of their existing bonds did not create enough value to maintain or increase their net income, then the decision becomes more difficult.

The most common strategy and solution to this dilemma is to create a fixed income portfolio with laddered maturities. A simple example would be to put 10% of their portfolio into one-year maturities, 10% in the 2-year maturities, 10% in the 3-year maturities, and so on. Moreover, the ladder can be created with longer or shorter-term limits based on the investor's view of future interest rates and/or their risk tolerances. In other words, when investors are uncertain, they might shorten the ladder to only 5 years, with 20% of their available money placed into each year. Of course there are numerous other ways that the portfolio can be laddered.

The greatest advantage to doing this is that it does not expose the entire portfolio to interest-rate risk. When their first bonds mature, fixed income investors have the choice of reinvesting at the long end or the short end of their ladder. This decision would be predicated on their views of where they believe future interest rates are, or are headed. In other words, they can be more aggressive by investing in the longer side if they think interest rates might fall, and vice versa. Although there is no guarantee that they will be right, at least they're only exposing a portion of their portfolio to future interest rate risk.

Issuer Risk/Credit Risk

The quality of the issuer of the bond or other type of fixed income instruments is another risk that investors in fixed income face. The higher the quality of the instrument, typically the lower will be the yield it offers. The key risk factor here is the potential for default. Typically, fixed income investors will rely on the credit rating that the bonds or fixed income instruments they are considering possess. Of course, U.S. Treasury bonds and notes are considered the safest of all. For corporate issues, only research and due diligence can mitigate their risk.

Tax Risk

Due to the limited level of return that fixed income instruments provide, future tax rates represent an elevated risk that they must consider. Although there is little that can be done to avoid this risk, the diligent monitoring of tax codes is implied.

Of course there are also tax sheltering options that can be utilized. Qualified retirement accounts and municipal tax-exempt securities are two examples. Of course, the difference between tax-deferred and tax-exempt is also relevant. Municipal bonds that are tax-exempt typically offer the lowest yields. Qualified retirement account fixed income holdings will eventually be taxed when the shelter no longer applies.

Market Risk

Although technically speaking, there should be less exposure to market risk with fixed income investments in the general sense; they are not without risk entirely. In a stable interest-rate environment the principal value of bonds will generally be quite stable. However, they can fall substantially during rising rate environments, but only appreciate moderately during falling rate environments. Investors should recognize the limited upside that bonds offer.

For example, I have never seen a bond trade at 300% of its par value. Conversely, I have seen bonds trade at discounts of 50% or more to par value. Therefore, a limited upside coupled with the potential for a large downside is a risk consideration that cannot be ignored. Nevertheless, the same strategy suggested in the interest rate risk section can be utilized to mitigate market risk.

Opportunity (Reinvestment) Risk

Opportunity risk is rather straightforward and applies to both fixed income and equities. However, due to the limited appreciation potential available from fixed income, opportunity risk associated with fixed income investments is more pronounced. Opportunity risk simply means choosing an investment over one that provides a greater opportunity for return. Of course, the willingness to accept a lower return with less risk over a higher one with greater risk is relevant to the risk tolerance of the individual making the decision.

Inflation Risk (Deflation)

Inflation reduces the purchasing power of our dollars. Since the returns available from fixed income are fixed, they provide no protection against the ravages of inflation. Not only does this affect the purchasing power of the current yield the fixed income investor is receiving, it also means that their nominal return of principal at par is also worth less. In other words, they can generally expect the return of their principle in nominal dollars, but inflation reduces the purchasing power of those dollars.

In contrast, deflation would work in the opposite manner. Therefore, fixed income investments do offer deflation protection. However, historically speaking, the risk of inflation occurs more frequently than the risk of deflation. On the other hand, deflation cannot be ruled out as a possibility.

Call Risk, Political Risk, Currency/Exchange Rate Risk

There are several other risk attributes that fixed income instruments can be exposed to. The above represent just a few. At the end of the day, the risks normally associated with investing in fixed income instruments are arguably lower than the risks associated with equities. However, the previous statement implies that interest rates are within reasonable ranges of historical levels. Clearly, interest rates are currently abnormally low, therefore not within reasonable ranges of historical levels.

Therefore, and in my mind, this implies that fixed income investments carry greater risk today than they typically carry. Of course, this is primarily because of the extreme low level of interest rates today. Common sense would indicate that the odds favor a rising interest rate environment in the future. As discussed above, this would have a negative effect on pre-existing fixed income instruments.

However, for the sake of fairness, I don't believe anyone can say for certain when this might occur. If rates stay low for a long period of time, then the risk associated with fixed income investments are not that great. But that does not change the fact that fixed income offers very little real return currently. Therefore, I believe opportunity risk might be the biggest risk that fixed income investors face today.

The Most Prominent Equity Investments Risks

The variability associated with the price movements of equity investments is why most investors consider them riskier than fixed income. The fact that there is no guarantee of return of capital implied or real when you position yourself as an owner is clearly the assumption of risk. But in theory at least, the assumption of greater risk is also implicit with the opportunity for greater return.

At the extreme, equity investments offer both the opportunity for unlimited gain, while simultaneously providing a greater possibility for total loss. However, I believe that in the real world and during normal times, the risk of total loss is greatly exaggerated, yet not outside the realm of possibility. In contrast, the opportunity for unlimited gain is very likely if certain common sense actions are embraced and implemented. This would include buying great businesses at sound or low valuations.

Market Risk (Volatility)

In my understanding of modern finance theory, volatility seems to be the risk that is most focused on. However, I believe that volatility can be easily dealt with the proper knowledge and understanding of what it really is. The venerable Ben Graham talked about how to handle this in his seminal work The Intelligent Investor, more clearly and succinctly than I could as follows:

"A serious investor is not likely to believe that the day-to-day or month-to-month fluctuations of the stock market make him richer or poorer…. The holder of marketable securities actually has a double status, and with it the privilege of taking advantage of either at his choice. On the one hand his position is analogous to that of a minority shareholder or silent partner in a private business. Here his results are entirely dependent on the profits of the enterprise or a change in the underlying value of its assets. He would usually determine the value of such a private business interest by calculating his share of the net worth as shown in the most recent balance sheet. On the other hand, the common-stock investor holds a piece of paper, an engraved stock certificate, which can be sold in a matter of minutes at a price which varies from moment to moment - when the market is open, that is -- and often is far removed from the balance sheet.."

The following earnings and price correlated F.A.S.T. Graphs™ on the blue-chip 3M Corp. (NYSE:MMM) clearly illustrates why short-term volatility can and should be ignored as long as the underlying business remains strong and sound. Note how monthly closing stock prices (the black line), move back into alignment with the orange earnings justified valuation line, during bouts of volatility based on fear (red circles) rather than substance. I do not believe it's ever wise to sell a valuable asset for less than it's worth just because others may be doing it.

3M 7yr FAST Graphs showing fear
(Click to enlarge)

I wrote extensively on the subject in following three recent articles.

Own These World's Leading Brands And Never Fear A Recession Again

Why Accomplished Dividend Growth Investors Can Ignore Price Volatility

Volatility Is Not Risk

Total Loss Risk

I suspect that deep in the back of the minds of nearly ever investor that has ever owned a common stock lays the fear of total loss. Thankfully, the truth is that total loss rarely ever happens. Moreover, the total loss of the value of an entire portfolio is so remote that it's virtually impossible. But it does happen or comes close to happening on rare occasions for a given individual company. My point being is that total loss is not something that equity investors practically need fear.

But more importantly, total loss even more rarely, occurs in an instant or even overnight. A diligent investor will have ample warning that a business is deteriorating before a total loss occurs. The following Eastman Kodak (EKDKQ.PK) example illustrates my point. Although the long-term loss has been near total it took years of poor earnings results to occur.

EK 15yr FAST Graphs showing decline in earnings, dividends, and price
(Click to enlarge)

The following FUN Graph (Fundamental Underlying Numbers) reveals key balance sheet items on Eastman Kodak. Cash per share (cashps - the red line), and common equity or book value (ceqps - the green line) were clearly deteriorating.

EK 10yr FUN Graphs show declines
(Click to enlarge)

The next FUN Graph (Fundamental Underlying Numbers) reveals key items from Eastman Kodak's cash flow statement. Once again we see a clear downtrend in capital expenditures per share (capxps), cash flow per share (cflps), free cash flow per share (fcflps) and operating cash flow per share (ocfpls). Clearly, the diligent investor had ample warning that something was amiss.

EK 10yr FUN Graphs showing declines
(Click to enlarge)

"Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks." Warren Buffett

Valuation Risk

"Long ago, Ben Graham taught me that 'Price is what you pay; value is what you get.' Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down." Warren Buffett

Valuation risk is a subject that I have written extensively on, therefore, in order to spare the reader from what is already a long essay, I direct you to the following three articles on the subject. But the key to this risk is you can overpay for even the best of companies. Stated another way, you cannot buy what's popular and expect to do well. Stocks become reasonable or cheap when they are unpopular.

The Essence Of Valuation Is Soundness, Not Rate Of Return

Retirees Beware Of The Many Dangers Of Holding Overvalued Stocks

How Can I Know If My Stocks Are Fairly Valued?

Since pictures are worth thousands of words the following F.A.S.T. Graphs™ provide graphic evidence of the dangers of overvaluation. Simply note how price declines when overvaluation is present, even if operating results are strong.

HD 12yr FAST Graphs showing price declines from overvaluation
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MDT 10yr FAST Graphs showing declining prices from overvaluation
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Business Growth Risk

Even if an investor pays close attention to valuation risk, the risk of deterioration in the company's operating results (earnings) is another important risk that must be monitored closely. The four-year earnings and price correlated graph for American Greetings (Pending:AM) represents but one example. Even low valuation will not overcome poor earnings results (the orange line).

AM 4yr FAST Graphs showing beginning P/E and no growth
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AM 4yr FAST Graphs showing poor returns

Emotional Risk

At its most basic level, I believe emotional risk occurs when investors allow the big two emotions of fear or greed overcome their reason. Consequently, I believe that it's imperative that investors learn to overcome and manage emotional risk. Once again I will turn to Benjamin Graham in order to provide insights into emotional risk. The following excerpts come from Ben's book The Intelligent Investor based on updated commentary from Jason Zweig:

"Your Money and Your Brain

Why, then, do investors find Mr. Market so seductive? It turns out that our brains are hardwired to get us into investing trouble; humans are pattern-seeking animals…."

"But when stocks drop, that financial loss fires up your amygdala-the part of the brain that processes fear and anxiety and generates the famous "fight or flight" response that is common to all cornered animals. Just as you can't keep your heart rate from rising if a fire alarm goes off, just as you can't avoid flinching if a rattlesnake slithers onto your hiking path, you can't help feeling fearful when stock prices are plunging. In fact, the brilliant psychologists Daniel Kahneman and Amos Tversky have shown that the pain of financial loss is more than twice as intense as the pleasure of an equivalent gain. Making $1,000 on a stock feels great-but a $1,000 loss wields an emotional wallop more than twice as powerful. Losing money is so painful that many people, terrified at the prospect of any further loss, sell out near the bottom or refuse to buy more."

The following earnings and price correlated F.A.S.T. Graphs™ provides a graphical perspective of the fear response. During the great recession of 2008-2009 people panicked and sold perfectly good companies (stocks) even when their companies' businesses continued to perform strongly. I have circled the area on the AFLAC (NYSE:AFL) graph as a representative example of the fear trumping reason. AFLAC remained profitable during 2008 and actually raised their dividend by 20% from eighty cents a share in 2007 to ninety-six cents a share in 2008 (see the yellow highlights on the graph). Yet fearful investors were fleeing the stock (the red circle on the graph).

AFL 7yr FAST Graphs showing irrational behavior
(Click to enlarge)

However, although fear in my opinion is the most dangerous emotional risk that investors face, greed can be just as devastating to long-term results. The following F.A.S.T. Graphs™ on Oracle Corp. (NYSE:ORCL) for the time period 1998 through 2002 vividly reveals the danger of greed. Even though it should have been obvious that Oracle had become massively overvalued during this irrationally exuberant time frame, investors full of greed could not get enough Oracle stock.

At its peak, Oracle's P/E ratio hovered around a hundred times earnings. Reason would have told people that there was no possible or logical reasoning that could justify this lofty valuation. This is a clear example of nothing but pure greed at work. Clearly, the fall from $46.47 in August 2000 to a low of $7.25 in 2002 was catastrophic and devastating.

ORCL 5yr Ending 2002 showing greed
(Click to enlarge)

The rational practice of focusing on the business behind the stock, over short-term gyrations in its price is one sure cure for emotional risk. As Warren Buffett once so aptly put it:

"What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework." - Warren Buffett

Concentration (Diversification) Risk

It is inarguable that the proper implementation of diversification can greatly mitigate portfolio risk. On the other hand, and as the old saying goes, too much of a good thing can be bad for you. Therefore, I believe that investors need to be aware of practicing "Di-worse-ification," as Peter Lynch once called it.

Once again, I believe that common sense comes into play. In my opinion, a portfolio should be diversified enough to protect against catastrophic loss. On the other hand, it should not be so diversified as to relegate your future returns to average or worse. Furthermore, although I would not argue against diversifying your portfolio with different asset classes, I would argue against doing it capriciously. In other words, I would only include an asset class in my portfolio if I believed it provided acceptable long-term returns for the risk I assume by investing in it. Put another way, diversification strategies should be made based on your expectations about the future potential of the asset in question.

Moreover, I would never diversify simply because I believed that it might reduce volatility. The price of liquidity is volatility, and rather than try to avoid it, I prefer recognizing it for the paper Tiger it really is. I believe that once you understand that in most cases volatility can only hurt you if you succumb to it, then it can be ignored when it's appropriate to ignore it.

As it relates to equities, volatility can and should be ignored when it is being instigated by the emotional response as discussed previously. If the underlying fundamentals of what you are invested in remain strong, then volatility merely represents unrealized losses. Those losses are often not real unless you take them. In the long run, a sound investment will inevitably recover to its intrinsic value. Most rational investors don't build a portfolio with the intention of liquidating the entire portfolio at some future time.

"Wide diversification is only required when investors do not understand what they are doing." Warren Buffett

Economic Risk

"In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial conflicts; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497." Warren Buffett

Dividend Income Risk

If a retired investor, or an investor approaching retirement, builds a portfolio for the income it is capable of generating, then dividend cuts are a big risk that must be considered and dealt with. The key to building a good dividend growth portfolio is to identify and invest in companies with a legacy of and a commitment to regularly increasing their dividend. The CCC lists of companies with long histories of increasing their dividends provided by David Fish (found here) are one excellent resource that can be utilized to identify companies with superior records of dividend increases.

Like most risks, the risk of dividend cut can be mitigated with some proper due diligence and close monitoring of your portfolio companies. The following earnings and price correlated ten-year F.A.S.T. Graphs™ on General Electric (NYSE:GE) illustrates a once blue-chip that significantly cut its dividend during the great recession.

GE 10yr FAST Graphs showing dividend cuts during recession
(Click to enlarge)

GE 10yr FAST Graphs showing dividend cuts during recession
(Click to enlarge)

Summary and Conclusions

What I have presented with this article is merely a brief introduction to the multifaceted and complex subject of investment risk. Moreover, I barely scratched the surface on this very important consideration that investors of all types should be knowledgeable about and aware of. I cannot emphasize strongly enough the importance of dealing with and managing portfolio risk.

Additionally, I hope that this piece of writing highlighted the undeniable fact that the concept of risk cannot be relegated to simple statistical measures or metrics. On the other hand, risk is not so complex that it can't be managed and dealt with by applying a little common sense coupled with the understanding of sound fundamental principles and the willingness to do a little work. As I previously stated, the first and most important step in solving a problem is clearly identifying the problem in the first place.

Therefore, I believe it is critically important that investors are aware of and understand as much as they can about the multifaceted concept of investment risk. Whether we are initially creating their investment portfolios, or in the process of monitoring and managing them, risk awareness is vital. I fervently believe that knowledge is power. Therefore, a reasonable understanding of risk and how to effectively deal with it is a knowledge that can reduce most of the stress associated with running an investment portfolio.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Source: Common Sense Strategies For Mitigating Risk In Your Retirement Portfolios: Part 2