RiskMetrics - Managing risk with RiskGrades

Managing risk with RiskGrades

Understand how to target appropriate levels of risk by benchmarking yourself against peers and indices

Benchmark yourself

How do you know when you're taking too much risk? Or not enough? To start managing your risk you first need to define a target risk level that is consistent with your goals, capacity for taking risk, and risk tolerance. Benchmarking yourself against peers, indices, and common asset allocations can also provide valuable perspective. Is your risk level within norm or an outlier?

Comparison with peers

When we first met him, Matt S. Tuffer was fatalistically waiting for an apocalyptic market crash while making measly money market returns. But after taking Understanding Risk, he realized that risk could be viewed as opportunity, and that not taking enough risk only guaranteed his long term underperformance. He then targeted a RiskGrade of 30 by allocating a portion of his assets to mutual funds. While still conservative, with a Risk Ranking of 22% relative to peers (e.g., 78% are taking more risk), Matt is now confident of achieving his investment goal of generating income without excessive volatity.

Comparison with other indices

Wanda Lottery is another story altogether. With her margined Internet stock portfolio, her RiskGrade peaked at 1100 (yes, that's eleven times normal equity market risk!). Her Risk Ranking revealed that 99% of stocks in the NASDAQ 100 had a lower RiskGrade than her portfolio, and that 98% of investors took less risk. No wonder her portfolio behaved like a rollercoaster on steroids: her December 1999 ICGE stock investment tripled in that month and then lost over 80% of its value within the next three months. Having learned that laws of gravity can apply to Internet stocks also, she de-leveraged and diversified her portfolio. While still aggressive, she now has a more palatable RiskGrade of 156 and a Risk Ranking of 80%.

Comparison with other indices

Where should you be? Take enough risk to position yourself for long term growth, but not more than you can digest. Keep in mind that you can't expect higher returns without higher risk. And beware that the risk inherent in your current investment mix is likely to change over time because risk is not static (e.g., over the last five years, S&P 500 RiskGrades have ranged from 50 to 150, NASDAQ's from 100 to 300). You can, however, target a stable risk level by managing your asset allocation to reflect the current level of market risk (i.e., hold a lower proportion of risky assets, such as stocks, when market is volatile). Furthermore, you should gradually reduce your risk as you approach your investment horizon (e.g., buying a home, paying for children's school, retirement).

The graph below illustrates how the target RiskGrades of an aggressive, moderate and conservative investor might evolve as they approach their investment horizon.

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