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Investment Risk and the 401k Fiduciary: An Overview of Components

August 18
00:01 2011

(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

For several generations now, the axiom of investing has been balancing risk with return. As a result, investment theory evolved from the staid principals of centuries-old trust management to the statistics-laden complexity of Modern Portfolio Theory. In a sense, we replaced the Ten Commandments with something akin to 925917_59448610_cube_fragmenting_stock_xchng_royalty_free_300a gangster-run racket. The perceived relationship between risk and return became a zero sum game. It implied investors should be compensated for the risk they take. By relying on generic statistics to define risk (and, by proxy, return), Post-World War II investment theory discouraged investors from employing goal-oriented targeting while it encouraged their lust for raw return.

To extrapolate from our insurance metaphor from Part I, this is like the insured not using insurance to mitigate losses, but to insure only those items where the claim potential is greatest. Not only does this violate the statistical assumptions embedded within the actuarial tables, it also may violate several sections of the penal code.

What is the appropriate definition of risk? There are many factors comprising investment risk, each with its own definition and its own risk reduction strategy. Here’s a short overview of some of the more common components of risk:

Macro-Economic Factors: These involve risks that cut across a broad spectrum of investment classes, making them more difficult to mitigate.

  1. Political Risk – risk factors generally associated with the unexpected vagaries of sovereign nations.
  2. Social Risk – risk factors generally associated with changes in demographic issues.
  3. Technological Risk – risk factors generally associated with advancements in scientific and operational methods.

Fundamental Factors: These risks can be more easily isolated to specific market segments. Identifying the precise matters associated with each of these risks requires a subjective analysis. Mitigating these risks generally involve some sort of diversification within and among portfolios.

  1. Market Risk – risk factors isolated to a particular market.
  2. Industry Risk – risk factors isolated to a particular industry.
  3. Company Risk – risk factors isolates to a particular company.

Technical Factors: These objective statistics have long been used to quantify risk. One doesn’t necessarily mitigate these risks, but one uses this statistics to define risks associated with each element of the portfolio. Since these derive from Modern Portfolio Theory and are most responsible for the misuse of risk (specifically, in regards to “risk tolerance”), we’ll focus on these in upcoming parts to this series.

  1. Beta – pertains to the relationship between an individual stock’s price movements and the market’s price movements.
  2. Volatility – generally defined as a function of the standard deviation of an individual stock’s price movements.

Traditional Investment Factors: These categories of risk are self-defined within the investment industry. As we’ve noted earlier, they’ve evolved over time. (“401k Plan Sponsors: Is Your Investment Policy Statement Still Using Outdated Language?Fiduciary News, May 17, 2011) For years, the financial industry has mapped these risks to specific investment objectives; thus, permitting clients to positively acknowledge the risks they are taking.

  1. Capital Risk – the likelihood of suffering a loss of principle.
  2. Income Risk – the likelihood of suffering a loss of income. By focusing on total return, this risk has been eliminated (at least as it pertains to investment portfolios).
  3. Inflation Risk – the likelihood of suffering a loss of principle or income as a result of inflation.

Now, how do investors coordinate their personal risk tolerance with the many factors associated with investment risk? More importantly, how should a fiduciary best address these factors? Most importantly, does personal risk really matter?

Part I: 7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 2nd Deadly Sin – The Joy of “Risk”
Part II: Investment Risk and the 401k Fiduciary: An Overview of Components
Part III: The 401k Plan Sponsor’s Dilemma – What’s Wrong With “Risk”
Part IV: Why Risk Doesn’t Matter to the ERISA Fiduciary
Part V: Risk and the 401k Investor: How Plan Sponsors Can Avoid Misleading Employees

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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