Expert Roundtable on Risk
Updated May 31, 2011
To many people, the word "risk" has a negative connotation—something to steer clear of whenever possible. However, in the investing world, risk and performance are intertwined, and risk is something that just can't be avoided. Market sentiment can shift quickly depending on economic or political news, geopolitical events and even natural disasters, and these shifts can sometimes send investors fleeing for safety or taking on more risk as they seek higher returns.
Mark Riepe, head of the Schwab Center for Financial Research and president of Charles Schwab Investment Advisory, Inc., led a roundtable discussing the concept of risk in investing, strategies for reducing portfolio risk, and investment suggestions tailored to both risk-seeking and risk-averse investors.
Mark Riepe: Liz Ann, recently the terms "risk-on" and "risk-off" trades have entered the investing lexicon. What do they mean, and why is it important for individual investors to understand them?
Liz Ann Sonders: The environment we've been in the past couple of years has been very crisis-driven. There have been extremes in terms of news flow, so these two phrases have come in and out of play.
Risk on is basically when investors have been feeling better about the global economy and about the markets, so they buy and embrace more risky assets. Then, when fears rise—either longer-term fears or short-term fears driven by headlines—investors essentially avoid all risk. A key implication of this has been the inverse relationship between the stock market and the US dollar: When risk is "on," investors have moved toward stocks and away from the dollar.
In risk-off mode, investors have been selling stocks and moving to the relative safety of the dollar. The same thing has also been happening with stocks versus US Treasuries. In a risk-on mode, it's pro-stocks, anti-Treasuries and vice versa.
MR: So what should investors believe if they're going to position their portfolios in more of a risk-seeking mode, or to take advantage of an environment in which they're rewarded for taking risks?
LAS: I think it depends on what type of an investor you are and, more specifically, what your time horizon is. But, again, there are so many different types of investors—with time horizons as short as milliseconds for high-frequency traders and as long as multiple years for long-term individual investors—that I think the way each investor would answer that question would be entirely different.
For example, we know high-frequency traders account for 60-70% of trading volume on a day-to-day basis. When they're in risk-on mode, they may be looking for a one-day or even multi-hour opportunity to take some risk in their portfolios. For individual investors, I suggest not attempting to play that game.
If you think it's a longer-term risk-on environment, typically it would be a function of believing we're in a bull market (whether cyclical or secular will depend on your perspective) and that the economy is still growing.
MR: Randy, let's turn to you. Options are a classic method for changing the risk profile of a portfolio—you can really alter the dynamics of it quite dramatically. Describe some basic strategies for using options to reduce risk in a portfolio, and the profile of an investor who might benefit from these strategies.
Randy Frederick: First, please note that in order to use any of the strategies I discuss here, you must first be approved by Schwab to trade options in your account. There are really three main option strategies I discuss when I'm teaching people how to trade options: the covered call, the and the collar. The reason I focus on these more than others is that they are generally considered to be more conservative compared to other options strategies, so they may be appropriate for a larger variety of different investors; however, options are not suitable for all investors.
A covered call is when you sell a call option against a stock position you already own. This strategy can be useful if you're uncomfortable with day-to-day fluctuations in the market. Even if a stock only moves up or down 1-2% in a day or maybe even only 1-2% in a week, a lot of people don't like to see those kinds of fluctuations in their portfolios.
Selling a covered call against an existing position is not usually considered a risk-mitigation strategy, but the proceeds of the covered call can often bring in enough income to offset those ordinary swings and provide a very modest amount of downside protection, limited, of course, to the premium received for selling the call. It's a relatively simple strategy that I typically recommend as a very first options trade.
If you're more concerned the market may be getting close to a top and your bigger concern isn't so much trying to generate income but, instead, to protect the downside, then consider a strategy that works like an insurance policy: a protective put. It involves buying a put option, in most cases, at a strike price slightly below the current market price of the underlying stock. This way, if the stock you own drops sharply, you have the ability to exercise the put and sell the stock at the strike price. If you’ve had no appreciation in the stock, this means you'll take a loss, but a much smaller loss than you would have taken had you not had any protection.
A third strategy that I recommend is a collar. I think this is probably the best option strategy for people just seeking downside protection.
When the market gets rocky and people are concerned about the future, one common choice is to sell positions outright and just go into cash. But active traders often tell me they don't want to do that; they want to maintain their positions, while protecting them as best they can at the lowest possible cost. And if that's the objective, I think a collar could be the best strategy.
A collar really is just the combination of a covered call and a protective put. First, you sell an out-of-the-money covered call. The income that's generated is then used to offset the purchase the protective put.
Generally, the amount that the put is out-of-the-money is close to the amount that the call is out-of-the-money. This allows a small potential upside until the stock gets called away as the call option goes in-the-money. It also allows a very small amount of downside risk until the stock drops far enough that the put is in the money. And if the stock stays pretty much flat, both options may eventually expire worthless, which is okay because you can often execute this strategy at very little cost (or no cost at all).
The nice thing about the collar is that, unlike a lot of other option strategies, going further out into the future doesn't necessarily make it more expensive. You can put on a one-, three- or five-month collar, and generally the combined premium cost is going to be low because one leg is long and one is short, and the price of each tends to cancel the other out. Now, I caution people against putting on a collar for too long because it kind of puts you in a limbo state where you're protected to the downside, but at the same time you’re very much capped to the upside because you’ll forgo any profitability above the strike price of the call.
MR: Randy, in your example, you were talking about options on individual stocks. But there are options available on lots of different things, right? ETFs, indexes, many types of securities beyond stocks?
RF: Absolutely. In fact, ETF options, for the most part, trade in the same manner as equity options. They're American style, so you can exercise them at any time and they settle in the underlying ETF not cash. In fact, some of the most-actively traded options are on ETFs—the QQQ, the SPDRs and the IWM come to mind.
So for clients who've seen the benefits of trading ETFs to get exposure to certain market sectors or to provide portfolio diversification, they can write covered calls, buy protective puts or establish collars in those positions in the same manner as they can on individual stocks.
For those who trade options on indexes, it's a bit trickier. You can't sell a covered call on an index because you can't actually own an index, though you can own an ETF that's designed to achieve the same exposure as a given index.
If you have a well diversified portfolio, you may be able to protect your entire portfolio by buying puts on a broad-based index such as the S&P 500®. However, it’s difficult to obtain a perfect hedge and it's usually an expensive strategy; so much so that people often lose interest very quickly when I tell them how expensive it might be. I think it's typically better to just single out specific positions in your account that you have the most concern about and establish protection on those versus doing it for the entire portfolio. But options are actively traded on both stocks and ETFs. The majority of option activity on indexes is generally done by institutions.
MR: What are some basic options strategies investors can use to take a more aggressive posture with their portfolios?
RF: Most of the time, I talk to clients about how to use options for hedging or income generation. But if you're interested in the leveraging capabilities options have, there are all sorts of strategies available, even things as simple as just buying long calls and buying long puts.
I'm not typically a huge fan of those strategies, but I will say that if you're interested my one recommendation is to consider buying options that are already slightly in-the-money. They're typically going to be a bit more expensive, but, provided the underlying security or index moves in your favor; they generally have a greater likelihood of being profitable and are more likely to maintain at least some value as they approach expiration.
One strategy I teach that clients tend to find appealing is a , or CSEP. A CSEP can, in a sense, be compared to a limit order to buy a stock at a price that you'd be willing to pay. The nice thing is that unlike a limit order, you actually get paid a bit when you sell this put.
Now, the characteristics aren't identical, though they have some potentially similar outcomes. If you enter a limit order and the stock ever drops to your limit price, you'll end up buying it at or possibly below the limit price and you can change or cancel your limit price anytime without any cost. If you sell a CSEP using a strike price you're willing to pay, you will incur commission charges and the stock actually has to be below that strike price on the option expiration date in order to be assigned. It's possible you'd get assigned early if it goes to that price prior to expiration but that is less likely to occur.
But the nice benefit (which I think far outweighs the potential drawbacks) is that when you sell the CSEP it pays you money, even if the stock doesn't go below the strike price by expiration. And if it does, you get assigned and end up paying a very favorable price for the stock. Keep in mind that when you sell a CSEP, you’ll have to maintain enough cash in your account to cover the cost of the assignment, until the CSEP expires or is assigned. Additionally, if the stock is below the strike price at expiration, not only do you have to pay a commission, but you’ll also end up paying more than the market price when you get assigned.
The final strategy I'd mention for people interested in being a little more aggressive is trading vertical spreads. This strategy may be useful for investors interested in trying to profit from a stock that's either increasing or decreasing in value, but who really don't have any interest in owning the stock.
You don't have to have the same amount of cash outlay as to actually own the stock position, and people who trade vertical spreads by and large usually have no interest in owning the stock because they don't care about voting rights, dividends—whatever benefits actual ownership has. They mainly just have an opinion about a particular stock and whether they think it's going up or down, and they want to be able to take advantage of that opinion at a relatively low cost—and a vertical spread is a great way to do that as long as the options are not exercised or assigned.
I won't go into great detail, but it's essentially buying one option and selling another in order to capture the first couple of points of move, typically to the upside or the downside. You're not really concerned about extensive moves that might happen. If the stock does move sharply in the direction you expect, you’ll only be able to capture a small portion of that move, because while one leg of the strategy allows you to acquire the stock, the other leg requires you to sell it again. The difference between the buy price and the sell price, less any initial credit or debit is where your profit comes from. Of course if the stock moves sharply in the wrong direction, you could end up with a net loss as well. In either case, the maximum gain or maximum loss would be less than if you owned the stock outright.
People who tend to buy long calls usually say they have unlimited upside, but we all know stocks don't go up unlimited very often—in fact, they never do. What stocks tend to do more often is go up or down in observable ranges, and if that is your forecast, using a vertical spread is typically a much cheaper way to capitalize on that moves within those ranges when compared to purchasing the stock outright.
LAS: Could I just jump in quickly? Randy mentioned both diversification and ETFs, and I'd like to mention something that relates to them.
The rise of the use of ETFs, given that they basically buy and sell entire sectors or asset classes, has also tended to push up correlations, aside from just risk-on/risk-off. So it makes it more difficult to make a judgment about investments using old-fashioned criteria like fundamentals, valuation, etc.
Add to that all the excess liquidity the Federal Reserve has pumped into the system, hoping investors take more risk. With cash earning almost nothing, investors are basically forced to take big risks, but at the same time they're quick to want to take that risk off. So correlations are way up, sending a message to investors that diversification may not be that important anymore—you really just have to make the risk-on or risk-off decision.
But that's going to wane. We're not going to stay in this environment forever, which means correlations will come back down and diversification will rise in importance again. And I fear that because we've been in this environment for a while now, investors may shun the notion of diversification and it's going to be to their detriment in the long term.
MR: When you're talking about diversification in that context, are you talking about diversification between individual stocks?
LAS: Yes, diversification between individual stocks or even among asset classes that have recently been highly correlated, but that in a normal environment may become less correlated.
MR: Randy, talk a bit about people trading volatility. By that I mean instead of speculating on whether the price of something will go up or down, they're speculating on the volatility of something.
RF: There are products being introduced that are tied to the volatility of gold, oil or individual stocks, but they don't tie directly to those products the way you think they might, and it's very important that people understand how they work.
These products are very different, for the most part, from stocks, ETFs or index options. I think a lot of people are, unfortunately, not doing their homework—not reading prospectuses or explanations of how these products work—and the products end up not performing the way investors expect. So I want to caution people: If you want to trade volatility, learn how it works, learn about the products and make sure you understand them before you jump in.
The specifics can vary a lot, but it's important to understand that many volatility based products are affected by the volatility term-structure or they're tied directly to futures markets, so they won't necessarily correlate directly to the underlying stock, ETF or index the way you might expect.
MR: Rob, let's go over to you. I've heard you say many times that the bond market is much more varied than many people realize. Could you describe the different segments, especially with regard to risk?
RW: Sure. Historically, bonds have been the asset class that represented a risk-off trade—especially bonds with the lowest credit risk, such as US Treasuries, municipal bonds and agency mortgage-backed securities—the portion of the bond market with some government support.
In spite of debates about the US budget and potentially hitting the debt ceiling, we believe the federal government will make good on its bond obligations. During times when investors worry about market risk, you see the "flight to safety" trade with investors moving into government bonds. And when investors are in a more risk-on mode, they move into stocks and other higher-risk investments.
In recent years, we've seen a strong recovery in sectors with higher credit risk. Both in the United States and globally, investors have found higher yields with higher credit risk in investment-grade corporate, high-yield and emerging-market sovereign bonds. Generally, these come with higher risk, but also higher yields that some investors seek.
When you add higher-risk bonds and are adding additional yield, it's good to ask yourself a couple of questions. The first is about credit risk: Are you going to be repaid? The second is about interest-rate risk: How long will it take to have your principal returned, and will interest rates change in the meantime? Both credit risk and time add risk.
Another important consideration is inflation expectations. Bonds don't tend to fare as well if inflation rises at a rate much faster than markets expect, and that's increasingly important the longer the period is until you're repaid.
So, there's risk even in Treasuries, especially those with longer maturities. In the current low-interest-rate environment, we see a fair amount of risk in holding long-term Treasury bonds if you're worried about keeping up with inflation as well as volatility in the short term if rates rise, not just whether you'll be repaid when bonds mature.
MR: If I'm worried about the economy weakening and interest rates coming back down, would a long Treasury position be a risk-off trade?
RW: Yes, a lot of institutional investors view long-term Treasuries as the sector of the bond market that's generally going to move the most in the opposite direction from stocks. So if US stocks fall, long-term Treasuries tend to have the most volatility and move to the most extreme in the opposite direction. So they can help offset a decline in the value of stocks.
That said, we're in a very low-interest-rate climate today, so risks are elevated if you do buy Treasuries with long maturities. We don't see as much value for individual investors in longer-term maturities in the current climate even if you want the diversification benefit. Although there's the chance of a weakening economy, we think we're likely to be in a cycle where rates are starting to move slowly upward as the Fed moves its interest-rate policy back to normal and the economy continues to recover.
MR: I've heard you mention before that when looking at the differences in yield among different types of bonds, you've characterized that yield differential, or spread, as the "price" of risk: in other words, the amount you're getting paid to take on the extra risk associated with a type of bond. What do you look at in terms of spreads to tell whether risk is properly rewarded?
RW: This is a challenging question—one of the see-saws of financial markets that's really critical to understand if you're not just a buy-and-hold investor and you worry about the fluctuation in value of your bond investments in comparison to the rest of your portfolio. And that's the ebb and flow of the "spread"—the yield you receive over-and-above a bond with no credit risk, such as a US Treasury with the same maturity.
In 2008, when we were in the midst of a credit collapse and the risk-off trade had kicked in so strongly, investors willing to take on credit risk could buy, for example, high-yield bonds with yields 15 percentage points or more higher compared to US Treasuries. Today, we've moved back to a more normal relationship where the spread on a portfolio of high-yield bonds is about five percentage points higher than a 10-year Treasury. That's a pretty good pick-up in yield, but it does come with higher credit risk. Whether you're being adequately compensated for that risk really depends on your time horizon and risk tolerance.
MR: As the economy and markets have recovered, yield spreads have narrowed. What are shifts you could make to your bond portfolio if you feel those spreads are getting too tight?
RW: A lot of institutional investors, bond fund managers that have flexibility, are overweight in the so-called risk-on trade—meaning they're more heavily allocated toward bonds with higher credit risk (corporates, high-yield bonds) than to lower-risk bonds like US Treasuries.
Because of the extreme government intervention into the economy (the Fed purchasing Treasury bonds and the continued low-interest-rate environment), while we don't necessarily expect yields on government-sector bonds to go through the roof immediately, there's much less upside to holding them now.
MR: Brad, let's go over to you. We divide the stock market into 10 economic sectors. Which ones make the most sense for a risk-on stance to a portfolio, and, conversely, which make the most sense if you're in a risk-off mode?
Brad Sorensen: First of all, it's good to point out that you can remain invested in stocks even if you're in risk-off mode. A lot of investors think that if you're concerned about risk, you need to get out of stocks or severely pare back your exposure, and we don't recommend that.
Whether in risk-on or risk-off mode, having exposure to stocks is important, and being diversified among the 10 sectors is equally important. By overweighting and underweighting among them, you can take on more risk or remove a little risk from your portfolio.
If you're looking to add a little risk, then look at sectors that typically benefit from increased economic activity: for example, consumer discretionary, energy and information technology.
In a risk-on environment, consumer discretionary is good to consider because consumers tend to spend more money when the economy is doing better. The energy sector also benefits because companies use more energy and consumers travel more. Information technology tends to do better as consumers spend more on technology items and businesses are more willing to invest in technology to enhance their business products and efficiencies.
Conversely, if you're concerned about the economy and want to lessen risk in your stock portfolio, there are what we call "defensive" sectors—those whose products consumers and businesses will use no matter the economic environment. For example, consumer staples are things consumers will buy regardless of what the economy is doing. Health care also tends to do well during risk-off times. People are going to spend on health care no matter the economic environment. The utilities sector also does well during risk-off periods and pays decent dividends that have remained steady over the years.
RW: If I could just add to that, we're obviously in a very low-yield environment, so income-oriented investors faced with that income-generating challenge may actually be taking on more credit risk than they anticipate. To Brad's point about dividend-paying stocks, they're still stocks with stock-like risk. However, they can also generate dividends that are likely to grow, and that's a relatively defensive way to add income to a portfolio in the stock allocation. And that's generally considered part of the risk-off trade, as well.
BS: That's a great point, and I want to add that it's easier than ever to make risk-on/risk-off adjustments within your portfolio with exchange-traded funds. You can add to or subtract from any sector by buying that sector's ETFs, and all 10 sectors have them so that makes it much more convenient and cost-effective than trying to buy seven or 10 individual securities within a sector. The advent of ETFs has really made it easier for individual investors to shift within sectors.
MR: All right, Liz Ann, let's wrap up with you. We've been talking about risk-on/risk-off as though the world falls into this black-and-white scenario and there's this perfect kind of clarity on the future. Reality is a little bit more complicated. What are your thoughts on that?
LAS: I think the reality is always more complicated. As individual investors, we can get wrapped up in whatever the short-term forces are: "What do I need to get in and out of right now; and what's the hottest new asset class?" But to be a successful long-term investor, you need a long-term plan that includes the time-tested ideas of asset allocation, diversification and rebalancing. Those strategic principles apply whether you're in a tactical risk-on or risk-off trading mode.
Resources and Next Steps
Call our main line at 800-435-4000.
To speak with a Schwab fixed income specialist, call 877-563-7818.
If you're a client, you can access:
ETF Center
Mutual Fund OneSource Select List
Schwab Equity Ratings
Get tactical investing ideas from our Schwab Sector Views.
Important Disclosures
Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges, and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
Investment returns will fluctuate and are subject to market volatility, such that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Past performance is no guarantee of future results.
Some specialized exchange-traded funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.
Fixed-income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Potential share price movements of long-term bond funds cause greater risk to principal than with shorter-term funds. Lower-rated securities are subject to greater credit risk, default risk and liquidity risk. Government bond fund shares are not guaranteed. Their price and investment return will fluctuate with market conditions and interest rates. Shares, when redeemed, may be worth more or less than their original cost.
Since a sector fund is typically not diversified and focuses its investments on companies involved in a specific sector, the fund may involve a greater degree of risk than an investment in other mutual funds with greater diversification.
Commodity-related products, including futures, carry a high level of risk and are not suitable for all investors. Commodity-related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions, regardless of the length of time shares are held. Investments in commodity-related products may subject the fund to significantly greater volatility than investments in traditional securities and involve substantial risks, including risk of loss of a significant portion of their principal value. Commodity-related products are also subject to unique tax implications such as additional tax forms and potentially higher tax rates on certain ETFs.
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. With long options, investors may lose 100% of funds invested. Multiple-leg options strategies will involve multiple commissions. Spread trading must be done in a margin account. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received. Protective puts will increase your cost basis in the underlying security. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options."
Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies. Supporting documentation for any claims or statistical information is available upon request.
Schwab Sector Views do not represent a personalized recommendation of a particular investment strategy to you. You should not buy or sell an investment without first considering whether it is appropriate for you and your portfolio. Additionally, you should review and consider any recent market news.
This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. All expressions of opinion are subject to change without notice in reaction to shifting market conditions.
Risk-management includes an effort to monitor and manage risk, but should not be confused with (and does not imply) low risk or the ability to control risk.
Diversification does not eliminate the risk of investment losses.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
Charles Schwab Investment Advisory, Inc., is a subsidiary of The Charles Schwab Corporation.