by Samuel Won
Published under Newsletters of AICPA
March 17, 2011
The famed investor, Warren Buffett, said, “You only find out who is swimming naked when the tide goes out.” After the financial crisis in 2008, unfortunately, many investors in both large and small firms made the grim discovery that their investment advisors had done little or nothing about the risk management of their investment portfolios. There is no debate among both financial experts and academics that most, if not all, of the financial crises and failures of the last millennium were, at the core, failures in risk management.
Today, investors now demand that their investment advisors focus much more of their attention and resources on risk management considerations and issues related to their investment approach, selections and decisions related to their clients’ investment portfolios. In addition, new regulations stemming from financial reforms after the financial tsunamis of 2007 – 2008 will likely include more requirements regarding risk management, risk transparency and fiduciary responsibilities for asset managers and investment advisors.
What Is Risk Management?
In its simplest form, the term “risk management” can be defined as what one does about risks (investment risks) once they have been properly identified and measured. It is crucial for investment advisors to understand that investment risks must be identified, measured, monitored and minimized in accordance with their client’s risk tolerance levels or parameters and investment objectives. However, these risks can never be eliminated and, furthermore, are not constant; they are subject to dramatic change, based upon both market forces and factors that are external to the financial and investment markets.
How Can Investment Advisors Become Risk Managers?
Given the undeniable fact that investment advisors must now take risk management issues and factors into account when advising their clients, they must provide risk management strategies and guidance as an integral part of providing clients with a robust and holistic investment process.
In order for investment advisors to become “risk managers,” they must address four major areas of change:
1. Client’s Risk Parameters
Before an investment advisor begins to think about advising their clients on target returns, investment selection or asset allocation, a client’s risk parameters must be clearly defined in conjunction with direct input and sign-off from the client. Properly defined risk parameters should fully take into account such risk management considerations as a client’s maximum tolerance level for investment “down side,” requirements for liquidity and appetite, if any, for financial leverage. In addition, the client’s risk parameters should be the starting point for creating a strategic risk and investment management plan for the client. These plans should not be static documents; instead, they must be periodically reviewed and modified as the client’s investment and risk management needs and risk parameters change or evolve.
2. Risk Measurement and Monitoring/Review
In order to ensure that a client’s portfolio is being properly managed, it is crucial that the market, credit and liquidity risks associated with a client’s portfolio are being properly identified, measured, monitored and communicated. Investment advisors need to make sure that their firms have the analytic capabilities and proper infrastructure (e.g., staff, systems, processes) to provide their clients with risk measurement, risk management and monitoring. Alarmingly, most investment advisory and wealth management firms do not have the risk infrastructure necessary to provide their clients with adequate guidance on risk management issues and considerations.
3. Risk Management Training
In order for investment advisors to provide the proper risk analysis and guidance to their clients on risk management, they must first receive more instruction and training in risk management from an experienced and qualified firm that can provide this training to them.
4. Risk-Focused Culture
Finally, the most important starting point for investment advisors to begin providing strong investment risk management to their clients is when investment advisors make several important internally-facing and externally-facing cultural changes. On the internal side, investment advisors must adopt a new culture in which risk management and not “returns” is the overriding tenet in advising clients on their investments. On the external side, investment advisors must educate and communicate with their clients on a regular basis so that these clients fully understand that returns cannot be produced without taking risk, that getting more return means taking more risk and that having well-defined risk parameters and risk defeasance measures prior to investing in any single investment or portfolio of investments is critically important.
Conclusion
Until investment advisors make significant strides in making these internal and external risk culture changes, and until they undergo more training to become “risk literate” themselves, they will be unable to have a risk management approach and process wither within their firms or for their clients. Until investment advisors possess the proper risk infrastructure, they will lack the necessary capabilities to provide their clients with risk management guidance, strategy and implementation.
Ultimately, without proper risk management infrastructure, processes and culture, investment advisors put themselves at legal risk for breach of fiduciary responsibilities and economic risk associated with the potential loss of clients and client assets. They expose themselves to being found out, as Buffett said in his famous quote, as being the ones who were “swimming naked.”
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