An important part of an advisor’s job is orchestrating the correct level of portfolio risk. How do you adapt the portfolio when clients need to reduce their risk levels?

First, know why they need the change. The goal of de-risking is to reduce the chances of capital erosion. Several developments can trigger this need, says Jay Nash, CIM, portfolio manager and vice president with National Bank Financial in London, Ont.

These include reappraisal of risk tolerance, or the need to rebalance a portfolio back to the original asset allocation after macroeconomic events. Some portfolios may also require tactical adjustments in anticipation of shorter-term developments such as market corrections.

“The Dow Jones corrects about 15% every couple of years on average,” Nash says, recalling last year’s correction and suggesting the possibility of another one next year.

Other factors include impending retirement, preserving assets for a charitable legacy, job loss, or a decision to move to a care facility, says Teresa Black Hughes, an advisor with Vancouver-based Rogers Group Financial.

The advantages of de-risking go beyond asset allocation; it also provides a measure of control for coping with macroeconomic forces.

How to de-risk a portfolio

To effectively de-risk a portfolio, analyze all assets—and therefore all risks—and include real estate as well as equities, bonds and mutual funds.

Nash says in today’s markets, some investors are avoiding equities. Yet many fail to recognize the risks of real estate. These risks include illiquidity and the potential for value declines. A tightening of credit will mean a tighter mortgage market, further increasing the risk of real estate.

“It looks like a near-perfect combination to stagnate the growth of property valuations, and maintenance costs are often higher than many mutual fund or ETF MERs,” he says.

Before the current explosion in real-estate prices, the market had been dormant for approximately 15 years.

If someone’s net worth consists primarily of real estate, he or she should reduce the level of interest-rate risk in other investments, Nash says. In fact, an RBC analysis demonstrates equities have outperformed real estate since January 31, 1993. Its RBC Canadian Dividend Fund Series A has outperformed select Canadian real estate markets, such as Calgary, Vancouver, Montreal and Toronto. The fund returned $2 million on a $300,000 investment (no leverage), while Calgary real estate returned only $925,027 and Vancouver real estate, $799,371.

Another risk lurking in portfolios is concentrating on low-interest instruments such as government bonds. Inflation and income taxes can eat those meagre returns.

“The general public appears underexposed to the [equities] market while it trades at P/E (Price/Earnings) levels that are historically low,” Nash says.

At the end of 2011, Canadian households held $1.08 trillion in cash, deposits, short-term instruments such as T-bills and money market-mutual funds, according to Derek Holt, vice president of Scotiabank Economics in Toronto.

De-risking solutions include non-correlated investments with strong track records. “Global equities have underperformed, partially due to appreciation in the Canadian dollar,” Nash says.

“But Canadians need to [increase their] global exposures on their equity portion. In the late 1990s, there was a real focus on the fact that Canada represents less than 4% of the global markets. Today this fact seems largely forgotten by investors.”

RBC Dominion Securities forecasts a drop to US$1,700 this year, $1,500 in 2014, $1,300 by 2015 and then a long-term flattening at US$1,200.

This strategy would reduce the risk of opportunity cost, since many global companies currently trade at lower multiples than major Canadian companies, Nash says, though he isn’t suggesting increasing the absolute weighting of equities in any portfolio.

Remove speculative investments

Reducing risk also means reducing clients’ gold holdings. The price continues to fall from its record high of US$1,900 an ounce in September 2011 (see “Gold to drop”).

Advisors also suggest eliminating highly speculative stocks, such as mining-exploration companies, says Black Hughes. She’s also considering reducing holdings in financial stocks.

“You wouldn’t want to be overweight in financial services as the economy tightens,” she says. Tightening could lead to layoffs and in turn to more defaults, reductions in the value of bank bonds and holdings, and ultimately the stability of share prices.

For clients nearing retirement, set aside at least one year’s withdrawals in fixed-income assets, such as a high-interest savings account. This will ensure they don’t have to liquidate equity assets that may have dropped in value.

De-risking can also mean reducing or eliminating sector-specific funds and ETFs (geographic or economic), since many have narrow investment mandates and limited diversification.

Those invested in fixed income have to find ways to protect their portfolios from rising interest rates, but also need to be careful to avoid taking on more risk than planned.

“When interest rates are low, some investors will go to great lengths to enhance the yields they have in the portfolio,” Nash warns.

Low-rated but high-yielding corporate debt may not be suitable, for instance. The higher the risk with this type of investment, the more likely it is to behave like an equity. “Few investors understand that bond values will fall during times of rising interest rates,” Nash adds.

Al Emid is a Toronto-based financial journalist.