Improving Transparency

The Federal Reserve today, for the first time, provided guidance on interest rates and an official estimate of inflation as part of its regular FOMC meeting. The Fed announced that, given its expectations for continued sluggish economic recovery and elevated unemployment, it does not expect to raise interest rates until 2014. The Fed also provided for the first time a specific inflation target of 2%.

There are a few important messages in this announcement. From a purely economic perspective, it is clear the Fed remains concerned about the pace of economic recovery and, at least for now, it does not view inflation as a problem. From the perspective of “communications”, there are also a couple of important messages. The Fed is trying to provide improved “transparency” to investors which, in turn, it believes will increase confidence in businesses’ willingness to make capital investments and hire new employees. Improved transparency should foster a higher level of trust in the Fed, or at least reduce the level of conjecture and uncertainty surrounding Fed policy which has greatly added to market volatility over the years. The idea here is improved transparency may reduce systematic risk to some degree.

So if the Fed is correct in its forecast for interest rates, there are number of issues that come up from a financial planning perspective. Sustained low interest rates reduce returns available from bonds which hurts individuals who may need higher levels of bonds in their portfolios. Lower returns may also force investors to rely more on certain equities for income, which could increase portfolio risk

As financial planners we can mitigate these risks in a number of ways. Investing in bonds issued by certain foreign countries can be a source of higher yields. For example, bonds issued by certain emerging market countries offer good credit quality at significantly higher yields than investment grade U.S. bonds or Treasury bonds. Certain categories of corporate bonds can also offer higher yields than U.S. Treasury or agency bonds. Investing in certain sectors of the equity market, such as preferred stocks, utility stocks, REITs, and quality high dividend-paying equities can also be a way to enhance portfolio cash flow or meet portfolio income requirements in the situation of very low bond yields, which we are experiencing now.

Striving for improved transparency has implications for financial planning as well as Federal Reserve policy. Greater transparency of things like plan goals and objectives, investment strategies, custodial relationships, financial statements, and accessibility, goes a long way to enhancing trust between client and financial planner. Given the headlines of the past few years, we can understand why people would be looking for greater transparency from their financial advisors. As the Fed is realizing, improved communication with important constituencies can not only increase trust, but also reduce risk.

Risk Management

……In Our Continuing Series “Am I Prepared?”

The past several years have been trying for many people planning for or entering retirement. The volatility of the financial markets has created angst and fear as people have watched the value of their capital fluctuate. Additionally, many peoples’ portfolios have not recovered fully from the 08-09 bear market. What these conditions have really driven home is the element of risk in investing, in this case, downside volatility. The great bull market of 1980s and 1990s created an environment in which risk was all but forgotten or downplayed. The focus then was a pro-risk, gain or greed environment, typical of bull market psychology. Now the focus is on risk avoidance driven out of fear of capital loss.

What is risk ?

Most of us would consider “risk” in the context of potential for downside or loss, in this case capital. There are a numerous factors that contribute to risk in investing, not all of which can be easily quantified. Some of the more common “macro” risks include economic risk, geopolitical risk, country risk or industry sector risks, interest rate risk, currency risk, inflation/deflation risk, valuation risk, etc. On a more “micro” level, some of the more common risks include company-specific risks or portfolio exposure risks. All of these factors create volatility in the markets.  

How do we deal with risk ?

 As financial planners, one of our most important responsibilities to our clients is to properly assess and manage risk in their investment portfolios. We do this by taking time to understand clients’ needs, goals, and lifestyle preferences, and carefully assessing their attitude and tolerance towards risk. This has an important bearing on the allocation of the assets in their portfolios which, in turn has an important impact on portfolio volatility (or risk).

Other ways in which we assess and address risk include: diligence in studying and understanding the overall market environment and the economic factors driving the markets; portfolio diversification; reducing exposure to company-specific risk through the use of index and/or exchange traded funds; portfolio hedging; and developing a sound financial plan. As we’ve said before, a sound plan helps to keep a client’s investments on course to achieve long term goals and reduces the risk of buying or selling at exactly the wrong time (otherwise known as “human emotions” risk).

Risk is part of investing, there is no way to get around this (even bank CDs have risk, albeit small). And there are always going to be major events and surprises that none of us can predict. In the end, the best way to mitigate risk is through proper portfolio allocation, understanding your risk tolerance, understanding and accepting what you don’t know, having a plan and sticking with it, and working with a professional you trust. By the way, you might want to ask your financial advisor how he/she is managing risk in your portfolio and have him explain it in a way that you understand and that makes sense to you.