Investment Risk and the Market Cycle – as Valuations Rise, so too Does Risk

Investment Risk – at Sprung Investment Management, we believe that investment management is about managing risk, not chasing speculative returns. Based on over three decades of experience, we also believe that as markets and valuations rise, risk increases.

investment managing risk pair dice future

Investment risk – managing risk is about one thing: dealing with the future.

Sadly, too many investors believe the opposite: at the nadir of a market cycle they think that risk is extremely high. They want to wait “until things look more certain” before investing. Of course, by the time that happens, stock prices have risen significantly. Today, as equity markets reach new highs, they continue to buy believing that the good times will continue.

Managing risk is about one thing: dealing with the future. No one can predict the future with certainty. Therefore, risk is inescapable. However, we believe that our three-part value investing strategy is the best way to reduce risk and volatility and earn consistent returns over time. Our diligent, patient and opportunistic approach has served our clients well, through good and bad markets:

  • Appraise the intrinsic value of each company over a business cycle;
  • Seek long-term growth of capital by investing in companies that we perceive to be mispriced;
  • Utilize a margin of safety to promote return of capital…not just return on capital.

Why does our value investing approach work? Investment risk arises primarily when investors become excessively optimistic and pay too-high prices for investments. The best way to reduce risk is to buy high quality assets at reasonable prices.

As we discuss in our recent quarterly commentary, we believe that after five years of rising prices, equity valuations are looking somewhat stretched. We are not market timers and do not attempt to predict short-term market movements. However, as conservative investment managers, we think it prudent to take some profits in securities that have substantial capital gains. When markets are going up it takes discipline to increase cash positions. Cash can provide a good option to purchase good investments on any market setback.

Many investors feel that there is no need to question their advisor’s approach if their investments are performing well. Nevertheless, high returns may be the result of a risky investment strategy such as an excessive exposure to an investment class (equities, bonds, or real estate for example,) a single market sector, (here in Canada many investors have significant exposures to the volatile energy and materials sectors.) Ask yourself the following question: how would I feel if the gains I made over the past two or three years were lost in a sudden market downturn next month or next year?

As an investor, you must be vigilant in reviewing the investments you hold. Given your individual time-frame, you may find it prudent to make some adjustments in your portfolio.

Download Our Free Special Report – How to Hunt For Value Stocks. Michael Sprung will share with you 5 stocks set for long-term gains.

Investment Risk – Is Your Stock Broker Acting in Your Best Interest? Read more here>>

Investment Risk – Exchange Traded Funds Expose Investors to Unexpected Risks. Read more here>>

Investment Risk – Risk vs. Return. Read more here>>

Investment Risk – we believe clients are more concerned about losing money than making speculative gains. Like to learn more? Please contact us here>>

The opinions expressed here are ours alone. They are provided for information purposes only and are not tailored to the needs of any particular individual or company, are not an endorsement, recommendation, or sponsorship of any entity or security, and do not constitute investment advice. We strongly recommend that you seek advice from a qualified investment advisor before making any investment decision.

Is Your Stock Broker Acting in Your Best Interest?

The OSC is considering imposing a ‘best interest’ duty on stock brokers. Their industry body is resisting.

OSC considers imposing best interest duty on stock brokers. Their industry body is resisting.

Is Your Stock Broker Acting in Your Best Interest?

How do stock brokers choose investments for their clients? Most investors assume that stock brokers (who call themselves investment advisors,) assess their client’s risk tolerance and investment objectives and select investments that best match them. Indeed, stock brokers are legally required to select investments that are ‘suitable’ for their clients. Unfortunately, ‘suitable’ is a very broad term–learn more here>>

Have a look at your investment account statements. Ask yourself the following question: how did my broker choose the investments that I currently hold?

Mutual Funds

There are over 5,000 mutual funds are available in Canada. They’re classified into more than 30 categories: bond funds, equity funds, sector funds, specialty funds, regional funds, diversified funds, balanced funds, index funds, etc. Stock brokers like mutual funds because they are paid sales commissions and ongoing trailer fees that are invisible to their clients. Did your broker choose a fund that meets your risk tolerance and investment objectives, or the one that pays him the most? How many funds are enough? Learn more about why mutual funds are still popular despite high fees and poor performance here>>

Stocks

There are thousands of stocks available on Canadian, US and international equity markets. One of the pitches that stock brokers make to prospective clients is, “as a client you will have access to our analysts’ propriety research.”  Brokerage businesses earn large fees by raising capital for publicly traded companies (known as IPO’s or initial public offerings,) and from mergers and acquisitions advice, (M&A’s). Studies show that the vast majority of analyst reports are buy recommendations, rather than hold or sell recommendations.

Exchange Traded Funds

Why have Exchange Traded Funds (ETFs) become so popular? Low cost diversification and low management fees are the main benefits touted by the industry. ETF fees are in the 0.5% range, compared with 2% to 3% for many large Canadian mutual funds. However, in many cases, investors are switching to ETF’s without fully understanding what they are buying. You can read more about the risks associated with ETFs here>>

While ETF’s may offer low fees, stock brokers often charge clients a management fee to select funds on their behalf.  Holding a large number of ETFs can lead to over-diversified and potentially inappropriate portfolio diversification in relation to clients’ risk tolerance.

Alternative Asset Classes

Over the past few years, there has been growing interest in ‘alternative assets’ such as hedge funds and private equity funds. These funds often promise higher returns than public equity markets and paradoxically, lower risk. Not surprisingly, many have failed to deliver either.

Hedge and Private Equity fund managers typically charge clients based on a ‘2 and 20’ fee structure: an annual management fee of 2% of assets, plus 20% of profits above a pre-set threshold. This means managers have a big incentive to take on more risk. They also share those fees with stock brokers who sell their funds.

How can you protect yourself from the many conflicts of interest inherent in the brokerage business?

In each of these cases, there is a potential conflict of interest between the clients’ best interest and stock brokers’ incentives to earn higher fees. The OSC is reviewing the potential benefits of imposing a fiduciary, or ‘best interest’ duty on stock brokers.  Not surprising, their self-regulating body, the Investment Industry Association of Canada (IIAC) is resisting this initiative. Learn more here>>

At Sprung Investment Management, we are discretionary investment managers, not stock brokers. We are independent of any bank or broker and our only source of revenue comes directly from our clients. We do not receive any kind of commissions or trailer fees from stock brokers or fund managers. We are committed to meeting a fiduciary duty. A fiduciary duty or best interest standard (already the norm for lawyers, accountants and some other professionals) is a legal requirement that we put the client’s interests first. Our investments are made in your best interest.

At Sprung, our investment management approach is based on the value investing principles developed by Benjamin Graham.  Graham explained that “the essence of investment management is the management of risks, not the management of returns.” Learn more here>>

The management of risk begins when a new client joins us. You will meet directly with Michael Sprung and other members of our team. We take the time to get to know you in order to understand your investment objectives and risk tolerance.

Based on that understanding, we begin to build a portfolio that includes high quality stocks and investment grade bonds. Whereas mutual funds often hold a large number of stocks, our client portfolios typically hold 20 to 30. If you hold more, gains in any single stock will hardly affect the total value of your portfolio. If you hold fewer, losses in any single stock can have an adverse effect on your portfolio.

On the fixed-income side, we hold good quality investment grade bonds. We manage the duration of your holdings to reflect our view of the existing interest rate environment.

In summary, the benefits of portfolio management include:

  • A personal relationship with the person who is actually making investment decisions on your behalf;
  • Holding a well-diversified portfolio that properly reflects your risk tolerance and investment objectives;
  • Avoiding the conflicts of interest inherent in the broker/ fund manager relationship;
  • Transparency—no hidden fees or commissions;
  • Lower cost.

Does your portfolio properly match your risk tolerance and investment objectives? Sprung Investment Management Is Pleased To Offer Qualified Investors A Free Portfolio Review—Without Cost or Obligation. Learn more here>>

UPDATE March 27, 2014: Barry Critchley of the Financial Post interviewed Michael on the topic of a best interest standard. You can read the complete article here>>

 

Mutual Funds vs Portfolio Management

Mutual Funds why are they still popular despite high fees and poor performance?

Many Canadians still hold their investment assets in mutual funds. This, in spite of a decade of lacklustre performance and high fees. Even the emergence of exchange traded funds (ETF’s) has failed to put much of a dent in the mutual fund industry. As of November 2013, mutual fund assets in Canada were $986 billion; Canadian investors held only $62 billion in ETF’s.

Brokers mutual funds sales commissions trailer fees invisible clients

Brokers like mutual funds because they are paid sales commissions and ongoing trailer fees that are invisible to their clients.

Before describing how portfolio managers work with their clients, let’s take a quick look at how mutual funds function. A mutual fund is an investment vehicle that is made up of funds collected from many investors. The manager invests those funds in securities such as stocks, bonds, money market instruments and other similar assets. Individual investors own units in the funds in proportion to the amount they have invested.

While the first mutual funds were founded in the 1930’s, they grew in popularity beginning in the 1960’s. In an era of high trading commissions, their main benefits were that they gave small investors access to professional management and diversification at low cost. With the advent of discount brokerage in the 1980’s and ETF’s in the past 10 years, mutual funds are no longer a low cost option. With many large Canadian mutual funds still charging fees in the 2% to 3% range, they are now an expensive way to invest.

Why have many mutual funds performed poorly? High fees are certainly one reason. Another is that mutual funds tend to be over-diversified. Larger funds have so many assets (i.e. so much cash to invest) that they have to hold hundreds of stocks. This can make it difficult for funds to outperform market indices.

Despite this difficulty, brokers and fund managers feel that clients expect them to out-perform the market. To do that they are forced to take on more risk. However, if a fund out-performs in a rising market, it will likely under-perform in a declining market. That is exactly what many Canadian investors experienced in 2008: while the TSX Composite Index declined by just over 30%, many supposedly ‘conservative’ large-cap equity funds declined by 40% or more.

Given the poor performance of many large Canadian mutual funds, why do so many investors continue hold them? Brokers like mutual funds because they are paid sales commissions and ongoing trailer fees that are invisible to their clients. It is also worth noting that there is growing evidence suggesting that the sort of people most likely to go into the lucrative financial service sales roles are precisely those least suited to judging risk. Read more here>>

What’s the difference between a portfolio manager and a broker?

It is a source of pride for us that we are discretionary investment managers, not brokers. We are independent of any bank or broker and our only source of revenue comes directly from our clients. We do not receive any kind of commissions or trailer fees. Sprung Investment Management is committed to meeting a fiduciary duty. A fiduciary duty or best interest standard (already the norm for doctors, lawyers and some other professionals) is a legal requirement that an adviser must put the client’s interests first. That includes avoiding all conflicts of interest and making the best recommendations for the client even if it means lower compensation.

Canadian securities regulators are reviewing the potential benefits of introducing a fiduciary standard for brokers. Their industry body, the Investment Industry Association of Canada (IIAC) is fighting against this proposal. Learn more here>>

At Sprung, our investment management approach is based on the value investing principles developed by Ben Graham.  Graham explained that “the essence of investment management is the management of risks, not the management of returns.” Learn more here>>  The management of risk begins when a new client joins us. Clients meet directly with Michael Sprung and other members of our team. We take the time to get to know our clients in order to understand their investment objectives and risk tolerance.

Based on that understanding, we begin to build a portfolio that includes high quality dividend-paying stocks and Canadian government bonds. Whereas mutual funds often hold hundreds of stocks, our client portfolios typically hold 20 to 25. We believe this is a sweet spot for diversification. If you hold more, gains in any single stock will hardly affect the total value of your portfolio. If you hold fewer, losses in any stock can have an adverse effect on your portfolio.

In summary, the benefits of portfolio management include:

  • A personal relationship with the person who is actually making investment decisions on your behalf;
  • Holding a well-diversified portfolio that properly reflects your risk tolerance and investment objectives;
  • Avoiding the conflicts of interest inherent in the broker/ fund manager model;
  • Transparency—no hidden fees or commissions;
  • Lower cost.

RISK IS A FOUR LETTER WORD: FREE PORTFOLIO REVIEW OFFER

With interest rates rising, investors are focused on risk. Many are exposed to more risk than they think.

Often, when a new client join us, we find that their existing portfolio exposes them to significantly more risk than they tell us they are comfortable with, based on their risk tolerance. With interest rates rising, we believe many other Canadian investors are in a similar situation.

Why does this happen? There are a number of reasons. A growing body of evidence suggests that the sorts of people most likely to go into the lucrative financial service sales roles have personalities that are poorly suited to judging risk. Read more>>  In an effort to improve returns, many advisors put their clients into securities such as long-dated corporate bonds, preferred shares, and so-called ‘high income’ funds.

free portfolio review

Our free portfolio review will help you understand the quality of your current holdings; whether or not they meet your investment objectives and if they align with your risk tolerance.

These attempts to manage returns unfortunately expose clients to higher risk. When the US Federal Reserve signalled earlier this summer that it might begin to pull back on its quantitative easing programmes, interest rates jumped and fixed-income securities experienced sharp declines.

You can view 10 year Government of Canada Bond interest rates here>>

At Sprung Investment Management, our portfolio management approach is based on managing risk. We define risk as: “Your funds not being available when you, the client, needs them.”

What our clients really care about is having their funds available to meet their lifestyle requirements. However, in order to mitigate this risk, we do look at, and measure, many of the more traditional types of risk that can affect the outcome. In the remainder of this article, we will describe some of the common forms of risk and describe how they may influence your portfolio.

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Are you at risk? We are pleased to offer qualified* investors our free portfolio review. It will help you to understand if your investment risk matches your personal risk tolerance. Ask us how>>

*Canadian residents with a minimum $500,000 portfolio.

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Opportunity Risk

Opportunity risk can be described as the “what might have been if only I had known better” risk. It is the amount of gain foregone by not having perfect knowledge of what is going to happen. For instance, if you knew what stock was going to be the biggest gainer tomorrow, each and every day, you would sell your current holding at the end of each day and buy tomorrow’s winner.

Unfortunately, studies have shown that investors’ belief that they can ‘time’ the market is an illusion. Read more>>

In order to compensate for the lack of perfect knowledge, portfolios are diversified into a range of holdings in different industries, asset classes, countries, currencies, etc. Opportunity loss or gain can be measured as the difference between the value of the portfolio and the value it might have achieved if the assets had been arranged differently (typically, according to the benchmark (discussed later) being applied.

Benchmark Risk

When you establish a portfolio, you want to determine what your long term goals are and then design the portfolio to meet these objectives within your tolerance for risk (there’s that word again), usually thought of as your threshold for losses in any given period. As time progresses, it is desirable to establish a means by which you can measure the progress of the fund. Hence, Benchmarks are chosen for the fund as a whole and often many of the fund’s components.

For the fund as a whole, it is common to use either an Absolute Benchmark or a Relative Benchmark. An Absolute Benchmark can take the form of a desired rate of return such as 8.0% after fees or 3.0% above the period’s inflation rate, typically the Consumer Price Index. Relative Benchmarks take the form of the S&P/TSX Total Return Index for Canadian stocks, the S&P 500 for US stocks, the ScotiaCapital Universe Bond Index for Canadian fixed income, etc. The total fund is then measured by a composite of the asset class returns in a predetermined proportion.

Be careful what you wish for! Setting too high of an Absolute Benchmark may cause a manager to take on a higher risk (a greater chance of large loss) than you can tolerate. Relative Benchmarks have to be chosen carefully. For instance, the S&P/TSX Total Return Index is composed with Financials, Materials and Energy stocks making up over 70% of the index at this time. A few years ago one stock, Nortel, comprised over 30% of the index. Is this prudent or proper diversification for your needs?

Other Risks

Asset mix decisions result in a lot of taking on a host of risk factors that need consideration, at least by your portfolio manager but of which you should be at least aware. The decision to invest in multiple asset classes such as equities, fixed income and cash will not only affect the expected return pattern of your portfolio but also the degree to which the return will vary from that expectation. Decisions to enter into multiple markets within asset classes such as foreign fixed income or foreign equities will further impact the return pattern as well as introduce currency risk (the fluctuations between differing currency values). Your portfolio manager should be able to demonstrate what these added risks entail and how they may benefit or detract from your objectives.

Investing in particular markets also creates factors to consider. If you are indexing to a particular market (buying stocks or derivatives to mimic the return of a market index), you will want to consider the composition of that index (see Benchmark Risk). Even when investing in individual stocks in a market, you take on some of the risk of the market as a whole. This risk is often referred to as exogenous or systematic risk. To explain, think of the saying “A rising tide lifts all boats and a falling tide lowers all boats”. This is the risk that when the market enters a “bear” period, most stocks fall including those of very good companies. Each security carries its own “specific” risk often referred to as endogenous or unsystematic risk. This risk has more to due with the particular company in which you are investing in terms of its financial position, market leadership, etc.

Summary

Risk is a word much bandied about by industry professionals without trying to enunciate the meaning of the term to clients. Yet, an understanding of the various types of risk and the impact that it can have on meeting your objectives is fundamental to constructing a portfolio.

With interest rates rising, investors are re-evaluating their risk exposure. Does your portfolio include contain hidden landmines that could implode as rates rise? If you are not sure, our free, no obligation portfolio review will help you understand the quality of your current holdings; whether or not they meet your investment objectives and how well they align with your risk tolerance.

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Are you at risk? We are pleased to offer qualified* investors our free portfolio review. It will help you to understand if your investment risk matches your personal risk tolerance. Ask us how>>

*Canadian residents with a minimum $500,000 portfolio.

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Warren Buffett Explains Investment Management to Katherine Graham

Warren Buffett, (age 44,) explains the futility of playing the market to Katherine Graham of the Washington Post

Warren Buffett Katherine Graham Washington Post

Warren Buffett explains the irreversible nature of pension promises to Katherine Graham of the Washington Post Company.

In 1975 at age 44, Warren Buffett wrote a letter explaining the futility of playing the market with some advice on how to invest pension accounts to the Chairman and Chief Executive, Katherine Graham of the Washington Post Company.

Fortune magazine recently published the 19-page letter in which Buffett makes the case against traditional stock picking and fund management. You can read the entire letter below.

The Washington Post was recently sold to Amazon.com founder and chief executive Jeffrey P. Bezos, ending the Graham family’s stewardship of one of America’s leading news organizations after four generations. The company’s newspaper division has been facing tremendous struggles in recent years; in the first half of 2013, it lost $49.3 million. The great surprise is the health of the pension plan.

Buffett wrote suggestions for the problems developing in pension plans, advice which Graham took resulting in the fine state of the Post’s pension plan.

Buffett was 44 at the time and was not as well-known an investment guru he is now. However, he managed to identify problems others would only notice years later. His key advice to Ms. Graham: think like an owner, look for a discount, and be patient.

In the letter, Buffett discusses:

  • The irreversible nature of pension promises
  • Deceptive arithmetic of “Promise now – Pay later”
  • Illustrated elemental actuarial principles
  • The “Earthquake risk”
  • The Investment management problem inherent in all pension plans
  • The history of corporate pension plan management

Here is Buffett’s pithy explanation of the statistical concept of regression to the mean:

If above-average performance is to be their yardstick, the vast majority of investment managers must fail. Will a few succeed due either to chance or skill? Of course. For some intermediate period of years a few are bound to look better than average due to chance just as would be the case if l,000 “coin managers” engaged in a coin-flipping contest. There would be some “winners” over a 5 or 10-flip measurement cycle. (After five flips, you would expect to have 31 with uniformly “successful” records—who, with their oracular abilities confirmed in the crucible of the marketplace, would author pedantic essays on subjects such as pensions.)

Warren Buffett Katharine Graham Letter

 

Interest Rates are up and Markets Volatile. Are Market Benchmarks a Good Way to Judge the Performance of Your Investments?

Investors expect their investments to outperform the market. With interest rates rising, that expectation may mean they are taking on more risk than they should.

When the US Federal Reserve signalled earlier this summer that it may begin to pull back on its quantitative easing programmes, interest rates jumped and equities swooned. As the dog days of summer draw to a close, investors may wonder how to evaluate their investments. When investors are evaluating an investment product, they often ask, “How does its performance compare with the market benchmark?”

interest rates rising investors risk

With interest rates rising, investors may be taking more risk than they should.

This seems like an entirely reasonable question. Investors are willing to pay a manager for improving investment returns and comparing returns with market indices is a good way to judge the performance of various investment products.

The Oxford Dictionary defines a benchmark as “a standard or point of reference against which things may be compared.” For example, Octane rating is a standard measure of the performance of gasoline. It compares the quality of the fuel you buy at the pump with an ideal fuel. Regular gasoline with an Octane rating of 87 provides 87% of the performance of pure Octane.

While pure Octane is an ideal fuel for the engine in your car, market benchmarks are not designed as ideal investment vehicles. Consider the S&P/TSX Composite Index, an index of the stock prices of the largest companies on the Toronto Stock Exchange (TSX) as measured by market capitalization. The Toronto Stock Exchange listed companies in the index comprise about 70% of market capitalization for all Canadian-based companies listed on the TSX.

The challenge with using the S&P/TSX Composite Index is that, far from being a benchmark or investment ideal, it simply reflects the nature of business in Canada. And what business is Canada in? You have likely heard the expression that we are ‘hewers of wood and drawers of water.’ In fact, resource companies (combining the energy and materials sectors,) comprise about 50% for the market capitalization of the TSX Composite Index.

That concentration in the resource sector means that the S&P/TSX Composite Index is highly volatile. For example, as commodity prices rose in 2009, the TSX moved up sharply. With commodity prices falling this year, the TSX has exhibited higher volatility and poorer performance compared with US markets.

Investors expect and even demand that fund managers earn their keep by out-performing market indices. In order to do that, managers must take on more risk. However, if a fund out-performs in a rising market, it will likely under-perform in a declining market. That’s exactly what many Canadian investors experienced in 2008: while the TSX Composite Index declined by 33%, many supposedly conservative large-cap equity funds declined by 40% or more.

Many investors will claim that they are aggressive investors when markets are rising. But when markets fall, they find they are in fact risk adverse.  Daniel Kahneman and Amos Tversky founded the field of behavioral physiology. They studied how people manage risk and uncertainty and concluded that investors are not so much risk adverse as they are loss adverse. They summarized their research by saying that “losses loom larger that gains,” in investors’ minds.

A robust portfolio should include high-quality dividend stocks diversified across the various sectors of the economy. On the fixed-income side, investors should hold bonds with short durations to limit the effect of interest rate hikes. We believe that over the next business cycle, equities will be the preferred asset class as the recovery gathers momentum and interest rates continue their assent.

Read more about interest rates and markets in our Second Quarter Commentary

You can read a good discussion of this topic at The Passive Income Earner

Interest Rates Are Rising. How Will They Impact Your Investments?

Interest Rates Are Rising. How Will They Impact Your Investments?

Interest rates appear to be rising– since the beginning of May, interest rates on 10 year government of Canada bonds have climbed from 1.67% to 2.43%. GCAN10YR If you hold bonds or high-income funds in your portfolio, you could experience significant losses if interest rates continue to climb.

Over the past 30 years, bonds have provided investors with significant capital gains, (offsetting declining interest income,) as interest rates have fallen from historic highs in the early 1980’s to historic lows last year. Ten-year US treasuries peaked at 15.84% in September 1981. In July 2012, they hit a low of 1.43%. Today, they are at 2.44% USGG10YR

Interest rates. Ten-year US treasuries peaked at 15.84% in September 1981

Ten-year US treasuries peaked at 15.84% in September 1981. In July 2012, they hit a low of 1.43%. Today, they are at 2.18%

Why are interest rates rising now? The US economy grew at a moderate annual rate of 2.4 percent in the first quarter of 2013–despite the effects of huge government spending cuts. As a result, the Federal Reserve is signalling that it may begin to pull back on its quantitative easing programmes. Markets are betting that higher rates are on the way.

Most experienced investors understand that as interest rates rise, bond prices decline. Unfortunately, many fail to understand that small increases in rates can lead to large declines in bond prices. For example, suppose you own a 10-year bond with an interest rate of 3%. If interest rates were to rise to 4%, the price of your bond would decline by approximately 9%.

As value-based portfolio managers, we do not attempt to time the market. We would simply observe that central banks will have to undo their massive stimulus programs at some point. And when that happens, interest rates will rise. We build robust portfolios, with high-quality dividend stocks as core holdings. On the fixed-income side, we currently hold bonds with short durations to limit the effect of interest rate hikes.

As a result of this conservative approach, our performance has lagged that of some so-called ‘high-income’ funds. However, many of these funds expose investors to significant risk due to large exposures to below investment grade corporate bonds, otherwise known as junk bonds.  As interest rates rise, the prices of junk bonds will drop much more that those of high quality government bonds.

Investors are often seduced by the promise of higher returns. However, think of returns as speed. If a travel agent offered you a flight on a brand new plane that would get you to your destination in half the time, you’d likely ask how safe it was. We all understand that there is no point trying to get to your destination in half the time if there is a significant chance that you are going to die on the way.

The relationship between risk and returns works the same way. If you reach for higher returns, such as by demanding that your advisor outperform the market, you are exposing yourself to greater risk. Higher returns almost invariably expose you to a greater chance of significant capital loss.

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Does your portfolio contain investments or speculative bets? We are pleased to offer qualified* investors our free portfolio review. It will help you to understand if your portfolio matches your personal risk tolerance. Ask us how>>

*Canadian residents with a minimum $500,000 portfolio.

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Investment Management – Risk vs. Return

Investment Management – Risk vs. Return

investment management risk return

“The essence of investment management is the management of risks, not the management of returns.” – Ben Graham

Investment management is generally defined as the professional management of various classes of securities—typically equities and bonds—in order to meet each individual client’s specific investment goals. At Sprung, our investment management approach is based on the value investing principles developed by Ben Graham.  Graham explained that “the essence of investment management is the management of risks, not the management of returns.”

That approach may seem counter-intuitive to many investors—and their advisors. They assume that investment management is all about managing returns. Many expect and even demand that their advisor out-perform market indices. What they fail to understand is that by doing that, they are in fact taking on more risk. If a fund out-performs in a rising market, it will likely under-perform in a declining market. This is exactly what many Canadian investors experienced in 2008: while the TSX Composite Index declined by 33%, many supposedly ‘conservative’ large-cap equity funds declined by 40% or more.

Seared by this experience, many investors pulled out of equities. However, with interest rates at historic lows, they are hungry for income. In response, many advisors have placed their clients into so-called ‘high-income’ funds. Many investors see the word ‘income’ and assume that these are safe, conservative investments. In fact, many of these funds expose investors to significant risk due to a large exposure to below investment grade corporate bonds, otherwise known as junk bonds.

Today, corporate junk bonds provide significantly higher yields than governments bonds, but they contain a hidden risk. As value investors, we tend to avoid date specific forecasts. However, a growing number of market watchers think that Obama may replace Fed Chairman Ben Bernake in August and end his easy money QE policy – read more here. This could lead to a jump in interest rates, causing longer-term bond prices to drop. As rates rise, the ‘spread’ or difference between government and corporate bond rates will widen.

If you own a fund with the words ‘high income’ in its name, you could be at risk.

Our investment management approach shifts focus away from chasing returns. Instead, we seek to reduce risk by focusing on company and market fundamentals by following our three-part value investing strategy:

  1. Appraise the intrinsic value of each company over a business cycle;
  2. Seek long-term growth of capital by investing in companies that we perceive to be mis-priced;
  3. Utilize a margin of safety to promote return of capital…not just return on capital.

We believe that investors are better served by following a value-based risk management approach, rather than chasing the latest ‘hot’ money products touted by many advisors.