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August upheaval exposes risks in returning to risk

19th September 2007
By IB Staff Writer

Despite a recent trend for investors to re-risk their portfolios, the market upheaval of August demonstrates that there are significant dangers attached to returning to risk. To mitigate the effects of future economic upsets, investment managers should seek to institute a smart, modern approach to risk and ensure that adequate advice is provided to clients.

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As the major market downturn of 2002 becomes a more distant memory, investors have increasingly looked to raise their tolerance of risk in their portfolios. This has been done in the hope of benefiting from the strong performance of the stock markets in the years since 2002.

Investors have become keen to achieve higher returns at the cost of higher risk

Investors' desire to achieve higher returns, and the subsequent increased risk inherent in their portfolios, is partially due to a lack of understanding on their part of the true risk underlying their investments. The clients of investment managers frequently underestimate the potential risks involved in some hedge funds, for example. However, the recent activity in the stock market - particularly in the US - serves as a warning to investment managers that, in order to mitigate poor performance in the event of more widespread equity market problems, they must both initiate a smarter strategy that optimizes risk, and educate their clients about measures and forms of risk.

Diversification acts as main factor in new strategic plan

Investment managers can construct a more modern and sophisticated strategy to manage risk in times of uncertainty over the direction of the market. This approach need not put investors at the mercy of the markets. Indeed, the key factors necessary for a successful strategy that minimizes potential damage include active management focused on monitoring high-risk areas, a longer-term focus for the portfolio, diversification of risk, and capitalization on market uncertainty where possible.

Of these, diversification is possibly the most important. In times of uncertainty, the clients of investment managers want to know that although they are targeting high returns, the risk inherent in their portfolio is not compounded by inadequate levels of asset class or geographical diversification. For example, risk is potentially compounded when investors rely too heavily on a single country or region, or weigh their investments across geographies in similar asset classes, or fail to ensure that a significant proportion of their investments are non-correlated to the stock markets or to each other.
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