Concerned About Risk? Take a Lesson from the Risk Experts
The last few months have seen investors getting reluctantly reacquainted with a thoroughly unwelcome houseguest: Mr. Risk. He's an annoying rascal. Never invited to our financial parties, he barges in anyhow, drinking all the punch, gobbling up all the shrimp, and scaring everyone half to death in the process. Without the slightest bit of remorse, he brazenly plunders anyone he is able to bully. It has been rumoured that he doesn't even brush his teeth. Then, without warning he vanishes, but his evil presence lingers. Will he be back? Should the party continue, or should we just hunker down, and buy GICs? Is he hiding somewhere unexpected? A few years ago he entered via the high technology entrance, but recently it was the commodity corner. Where will he be next?

We all know that Mr. Risk can't be completely avoided. Investing is rarely certain. Anyone who tells you they can earn high returns with no risk is either deluded or deceitful. Every story seems to have two sides to it: perhaps the economy is growing - but is it growing too fast? Will it lead to inflation? Or, if the economy is slowing, will that lead to lower interest rates, and … a new bull market? The population is aging -will it lead to low unemployment, or a labour shortage? And what about Europe, Japan, or China? Each market has its very own Mr. Risk. How do we handle them all at once?

In investing, as in most things, I'd suggest you take a look at what the EXPERTS do.

And who might the 'risk' experts be?

Well, there is a business that absolutely excels at analyzing the relationship between risk and return, and that business is… insurance. Risk is to insurance companies what coffee is to Tim Horton's: a matter of fundamental importance. Insurance companies are paid to take care of risk. It's their specialty. And they make a lot of money doing it. However, they certainly aren't stupid or careless about it either. They try hard not to accept bad risks. They make sure that, over the long haul, risk doesn't beat them.

Now, I'm not suggesting here that you run out and buy the shares of insurance companies. Nor am I recommending that you invest in insurance company products, such as insurance policies or annuities. These may very well be fine things to do, but that's not the point of this article. Rather, I want to know, "If insurance companies are so adept at handling risk, what, if anything, is it that we can we learn from them?"

Insurance companies face the risk of claims. They arise as a result of death, fire, automobile accidents, hurricanes, flooding, medical malpractice, product liability lawsuits - you name it, insurance companies have written policies to cover that risk. Are these risks uncontrollable? Is it all just a mere flip of the coin? Or do they try to somehow gain an edge in predicting whether a particular policy will be a safe bet or not?

Absolutely they do try. How? Through the gathering and analysis of information. For example, if you want to buy a large life insurance policy, the insurance company will want to know more about you. You will undergo tests to determine your health, and complete a questionnaire to disclose what activities you engage in. The insurance company will have predetermined views as to what types of things might make you a higher risk than others. It is certainly not a precise science - but that doesn't mean it isn't useful. They are operating on the probability that particular conditions or activities affect expected longevity - not the certainty.

I once purchased a life insurance policy in Singapore. The policy documents stated that the policy would be invalidated if I engaged in dangerous, high risk activities such as hang gliding, sky diving, flying in a small plane, or playing ice hockey! I remember thinking, " How ridiculous! They obviously don't have a clue about hockey!"

Now, it just so happened that there was one ice rink in Singapore at the time, which is not surprising in that steam bath climate, so I decided to check it out. It was tiny compared to Canadian rinks. As one might expect, the level of ice skating expertise in a tropical country was rather modest, to say the least. There were plenty of falls and collisions. After lacing up a well-used, appallingly 'fragrant' pair of rental skates, I took to the ice, my very average Canadian skating skills suddenly elevating me to expert status. Watching the Singaporean skaters struggling to stay upright made me realize that, in Singapore, perhaps ice-skating was indeed a risky activity after all. My reading of the risks involved in ice-skating changed once I gathered more precise information.

In investing, information is key. Not all risks are necessarily as they appear. Who would have thought 6 years ago that the value of Enron, purportedly a solid, American blue-chip company, would plunge to zero, even as shares in Russia (now with the world's second-largest trade surplus!) went up 7-fold? Information and experience help you know what risks are under-stated and which are over-stated. You can't avoid every risk, but you can get a pretty good handle on what risks you are willing to accept. It just takes a little work!

Well, what else do insurance companies do to handle risk?

They diversify - in two ways. The first way is by using large numbers - they write thousands of policies per year. For example, in the case of fire insurance, coverage for a $300,000 house might cost as little as $100 per year. Now, $100 is not a lot compared to a $300,000 risk. Would you insure your neighbour's house for $100? I sure wouldn't. But suppose on average one out of every 25,000 houses burns down each year. If the insurance company writes 25,000 such policies, and, as expected, one house burns down, then the insurance company is still profitable. They will have taken in $2.5 million in premiums, and paid only $300,000 in claims. In fact, they could withstand actual claims many times higher than usual and still cover their claims. As an investor, you should never put all your 'eggs in one basket'. Don't let one 'financial fire' wipe you out.

But not all diversification is created equal. Buying shares in the 5 major Canadian Banks will not give you the same diversification as investing in a French gas company, an Australian supermarket chain, a Japanese compressor manufacturer, and a Taiwanese shipping company. Diversification is more than just having a lot of names: there also had to be a lot of different types of investments.

But there is another, more interesting way in which insurance companies diversify.

Consider the following two insurance products: life insurance, and annuities. What are the risks to the insurance company in both cases? Well, with life insurance, the insurance company will take a large loss if the insured person dies early on in the life of the policy, because they will have to pay a death benefit. On the other hand, with annuities, the longer the insured person lives, the more the insurance company has to pay (annuities guarantee continuing payments for as long as you live). So in the one case, early death is the risk, whereas in the second case, long life is the risk. By issuing both types of policies, insurance companies can have one policy type offset the risk of the other. Can you do the same thing as an investor? You sure can. Let me give you two examples. There has been a lot of interest in the last two years in commodities. Of course, if commodity prices move higher, commodity producers share prices will likely also move up. But what if commodity prices tumble? How can you protect against the risk of that happening if you happen to own a portfolio with a lot of commodity exposure? Well, if you think about it, what is the opposite of a commodity producer? A commodity consumer! What is a good example of a commodity consumer? How about Japan, or Taiwan, or Switzerland? These countries have few natural resources, and as such are greater consumers of commodities than producers. So while a fall in commodity prices might hurt Canada, it should help these other countries. They help offset each other.

Or how about interest rates? What if you own a portfolio with a lot of bonds, income trusts, and other income-producing investments, and are fearful of what a sharp increase in interest rates could do to your portfolio? Is there anything that does better when interest rates go up? Yes, there is - floating rate notes. They are securities that increase interest payments as interest rates increase. Put a conventional portfolio of bonds together with floating rate notes, and suddenly your fixed-income portfolio is a lot less risky.

There's one more strategy insurance companies use to deal with risk. I call it faith.

Faith? Faith in what?

Faith in the long-term. Insurance companies know that from time to time there will be an unusually large number of fires in a given year. Or that once in a while there will be more large, destructive hurricanes than usual. But that doesn't deter them, because they know that in the long-term, things will return to normal. They have a sound, fundamental knowledge of the long-term results of following a policy of accepting 'good' risks, and they are not afraid to stick with their policy through unusually bad periods. History has taught them that bad times are followed by good times, as surely as night follows day.

Isn't it the same in investing? Hasn't a policy of maintaining ownership of a well-diversified portfolio of sound, profitable companies, along with fixed-income investments such as bonds and GICs been a consistent long-term winner? Looking back over the last 20 years, there have been numerous occasions when temporary market conditions led some investors to get so frightened of markets that they abandoned investing altogether. Each and every occasion where markets were under duress were in hindsight great buying opportunities. Not that you could buy just anything: remember, there are good risks and bad risks. Many technology stocks 5 years ago were very poor risks, not worth the price. They were the equivalent of insuring a house against fire for $10 per year - not $100. That's where a good advisor can help out - picking good risks.

If you are interested in learning more about how a well-planned portfolio can help reduce your level of investment risk while still providing the potential for high returns, feel free to call my assistant, at 905-704-6650, to arrange an appointment. I have over 19 years experience in the financial services industry, both in Canada, and overseas in Singapore and London. Together we can construct a sound, safe financial plan that will meet your investment needs.

Sincerely,

Scott Swallow, HBA, MBA, CIM