As the Fed begins the process of raising rates, there is a good chance that investment performance across asset classes may begin to diverge. The changes in correlations among asset return will likely lead to greater investor dissatisfaction with some investment advisors. Comparative returns for investors can often be more important than absolute returns, according to some studies on financial attitudes among investors.
The result of this divergence may be an uptick in the number of investment complaints against financial advisory firms. Adding to this is the potential for complaints related to the new fiduciary standards for retirement advisors. Advisors helping investors to make choices about 401K investments and other retirement instruments will now be held to the standards of a fiduciary rather than merely recommending investments that are appropriate to an investor’s risk tolerance. The latter standard allowed for some investment advisors to push products that carry higher commissions and costs but were still “appropriate” for an investor’s risk tolerance.
Underlying the changes in these risk standards is the implicit assumption that specific stocks, equities, and fund products are appropriate or inappropriate for a given investor. The reality is more nuanced. Investors should not be concerned with the individual holdings in their portfolio so much as they should be concerned with their portfolio and the correlation coefficients between different investments.
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In cases where I have served as a FINRA arbitrator, I have often seen investors and advisors overlook this critical issue. For instance, a volatile oil stock might be appropriate for a risk-averse investor if that oil stock is paired with an airline stock that carries a negative correlation to oil prices. In other words, put together, these two investments in theory might form a safe pairing while either stock on their own is risky.
Thus the broader point here is that investors, advisors, and the attorneys representing both sides need to think about the larger portfolio rather than the individual securities in a portfolio. This can either help or hurt a potential claimant’s case depending on the circumstances in question.
Beyond individual securities and portfolios, though, it is also important to consider how a portfolio is “tilted” towards what are called securities factors. Factors are the term used by financial economists like myself to refer to risks that are implicit in all investments. These risks cannot be diversified away regardless of how many securities are held in the portfolio, and investors receive compensation from the market for taking on these risks.
There are five different risk factors that are regarded as “priced” risks by financial economists, but not all of those risks are appropriate for all groups of investors. Unfortunately, because the risks themselves are not directly observable in a security, investors, advisors, and attorneys may overlook the risks and the ways they can help to advance a case.
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For instance, volatility risk in a portfolio of securities is priced but not explicitly. An investor buying stock ABC is not directly told how much they will earn from taking on volatility risk. Instead that risk is established by the market across all securities. A risk-averse investor who was not properly advised by their investment rep could be taking on an inappropriate amount of volatility risk and never even know it.
In light of these risk factors and the broader effects of portfolio composition on investment risk profiles, all parties involved in investment disputes need to carefully evaluate and quantify the type of assets being held in the portfolio and the associated risks of the portfolio broken down by the five factors. Failing to do this leads to a misleading and incomplete picture of risk and investment suitability.
Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively with organizations ranging from Fortune 500 companies to start-up businesses on financial matters through Morning Investments Consulting. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at [email protected].