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Understanding Investment Risk and Return

Self Study Course # 16

2 Understanding Investment Risk and Return SSC #16

Pro-Seminars International © 11/18

What will the Advisor learn by taking this course?

A financial advisor is required to know his/her client, including their tolerance for taking risks.

It’s your client’s life and their money, but how can an advisor really know their attitude of what risk they can accept unless the advisor gets to know the client and how they would handle any interest and market fluctuations.

Risk has multiple dimensions. One side is just the client’s willingness to take risk, or they have aversion to risk. Another side is the client’s capacity to endure financial loss.

For example, if the client is on a fixed income, based on their investments, chances are that they would be interested in low market risk investments. Risk perception is the final dimension

Our job as a financial advisor is to always review a clients’ tolerance and discuss their capacity and perceptions of what real risk is in their portfolio.

Risk aversion can be just as problematic in a portfolio as risk taking. A clear understanding of potential financial outcomes is the most important factor in being able to gauge market fluctuations which then can be matched with a tolerance level.

This course will cover:

• The 7 types of investment risks and how to protect against them.

• Definitions and explanations for various investment terms such as Probability Distribution, Reinvestment Rate Risk, Risk Tolerance and many more.

• Benefits of a well-balanced portfolio.

• The primary sources of market risk and how to deal with them

• How risk and returns can affect your client’s investments.

• Living with risk and returns.

• Inflation and how to protect against it.

• How to measure risk using Alpha and Beta.

• Asset allocation and what to look for.

• The 4 principles and examples of liquid risk management

• Risk control and financing alternatives.

• How to transfer various risks.

• Women and their investing principles and habits.

• An extensive look at the “Know Your Client” rule

• Various regulatory compliance requirements.



INTRODUCTION

What is Risk?

According to Webster's Dictionary risk is defined as:

Possibility of suffering harm or loss; A factor, course, or element involving uncertain danger; the danger or probability of loss to an insurer; The amount that an insurance company stands to lose; One considered with respect to the possibility of loss to an insurer.

We live with risk every day of our lives. If we drive a car, we run the risk of being injured in a car accident. If we are involved in dangerous hobbies, such as car racing, we run the risk of being killed. If we bet on a horse race, or invest in the stock market, we run the risk of financial loss. If we fall in love, we run the risk of emotional loss. Virtually everything we do in life involves risk to some degree.

Even Charlie Brown from the Peanuts comic strip experienced risk. When he got ready to kick the football, he never knew if Lucy would pull the football away leaving him to fall flat on his back. Those of us who read the comics knew that his risk was high (she always pulled it away). Charlie Brown was a risk taker. He always thought the next time would be a success.

When analyzing risk, there are many elements to consider. Past success or failure is one element that needs to be factored in. We know that some types of investments, such as annuities, carry guarantees of minimum return, and they have past performance histories, which allow the investor to evaluate probable future performance. Other types of investments, such as speculative stocks (or any stocks for that matter) have no minimum guarantees. Past performance does give the investor some ability to speculate on future performance, but it is only speculation. That is why they are called speculative stocks. There are no guarantees!

Investment risk is related to the probability of earning a return. The greater the chance of low or negative returns, the riskier the investment is. Certainly, no one invests with the idea of low returns or perhaps even a loss of principle. Everyone invests with the hope of high returns. When Bill Gates started Microsoft, those who invested in his company certainly knew there were no guarantees.

Those investors looked at Gates and what he hoped to achieve and took a "risk" with their money. Their risk paid off. However, for every Bill Gates and Microsoft, many more new start-up companies fail. With each failure, someone probably lost money.



Investment risk specifically refers to the probability of earning less than the expected return on an investment. Probability distributions provide the foundation for risk measurement.

PROBABILITY DISTRIBUTION

Probability distribution can be defined as a set of possible outcomes with a probability of occurrence attached to each possibility. Some investments have specific outcomes, such as the annuity with the guaranteed minimum interest rate. Even the annuity has another possibility, however. The minimum earning rate does not mean that the insurance company will not apply a higher rate. In fact, most annuities pay several percentage points higher than the minimum rate.

It should be pointed out that no investment is risk free. The T-bill for example is often said to be risk free because the rate of return is guaranteed. This is often referred to as a "zero risk investment.” In fact, every investment carries risk because every investment must contend with inflation. Only the nominal returns of the T-bill may be guaranteed. The real return cannot be. The real return refers to the actual buying power that the investment ends up with.

REINVESTMENT RATE RISK

There is another investment risk called reinvestment rate risk. There are several types of investments that must contend with this type of risk. The T-bill has a maturity date. When the T-bill reaches this maturity date, the money must be reinvested in either another T-bill or some other financial vehicle. If the prevailing interest rate has dropped, the money will begin to earn a lower rate than it previously was. It is this risk of a lower interest rate that is called reinvestment rate risk.

RISK TOLERANCE

Charlie Brown obviously had a high-risk tolerance. Why else would he repeatedly allow Lucy to hold the football? It means how readily a person can cope with volatility - the ups and downs of an investment or other situation.

If an investor cannot live with the investment because of its volatility or perceived risk, then obviously they should not be in that type of investment.

Volumes have been written about risk and what to do about it. Every financial strategy is based on a balance of risk and reward. Measuring risk is the most difficult part of choosing a financial strategy. Some people view putting their money into the stock market as too risky, so they opt for a more stable investment avenue, such as a banking institution. However, that may be even more risky about retirement planning.



It all depends on a person's time horizon. Time horizon is the amount of time available before the person will need their invested money. A thirty year old worker has another thirty years to invest whereas a fifty year old worker has only about ten or fifteen more years to invest.

If a person's time horizon is very short, they must make some serious decisions. They may want to put their money in short-term fixed-income investments.

Those who waited too long to invest for retirement must consider:

• Do I now need to invest in riskier investments so that I get higher returns?

• If I lose my money in a risky investment, am I able to replace the lost money through other avenues, such as earned wages? The older investor has fewer working years to replace lost investments.

• If I invest in conservative, less risky investment vehicles, will it yield enough income to live from during retirement?

The average retiree must be able to live at least twenty years without a working income. Many people must make their money last much longer, especially women who have longer life spans. Over a longer time, horizon, these "safe" investments may not be as wise. As with everything, different people have different opinions as to what is a short-term time horizon verses a long-term horizon. Some view five years short, others long enough to take a risk.

For those that view the stock market as a risk, they should look at the stock market's investment returns over several five-year blocks to see how the market has performed. Stock market historians and analysts can show that there has been no 20-year period in which a person would have lost money in the stock market (as defined by the Standard & Poor's 500 Stock Index) going back to the 1920”s.

Mutual funds, which are stock portfolios, have gained popularity because risk is spread out among many stocks rather than one.

People are scared by risks in the investment world. Thus people, especially younger people, make the mistake of choosing only the most conservative investments such as fixed-rate guaranteed investment contracts (GIC’s or Term Deposits) when they are planning their asset allocation models. Why is investing in these GIC’s a money mistake? The answer is because it is investing too conservatively in investments without growth potential.



A Critical Ingredient in Risk Is Time

Again, the critical ingredient in risk is time. Each person will define his or her time horizon differently. Some people may not need the entire principal for quite a long time, but they still want to keep of the principal in short-term investments. We see many people who continually use Certificates of Deposit, or Term Deposits for example, even though they are traditionally low yielding investments.

One of the most important things in overcoming risk is knowledge of the investment. It is common for people to invest in something merely because George at work did so, or Aunt Mary thought it sounded wonderful. No agent should ever recommend an investment without understanding it completely. Not only is it possibly a money mistake for the client, but it is also an errors and omissions mistake for the agent.

When investing, it is important that a person is educated and that it be a well thought out financial decision. Ethical investing has become popular, but it has also become known as one of the more successful investment strategies.

It has become successful not because it has to do with the ethics of a company (although there is that, too), but because ethical investing requires investigation.

How can an investor know if the company is bad on the environment or uses animals in testing unless they first investigate the company? Because of this investigation, the investor is also likely to uncover bad management, faulty management thinking, or failing company returns. Whether investing centers on ethical concerns or desired returns, investigation can mean the difference between success and failure.

The relationship between risk and return is simple: the greater the expected return, the greater the investment risk. Any company who promises higher returns is also undoubtedly promising higher risk of investment capital. Every investor needs to realize that some types of investment are risking not only interest earnings, but also invested capital.



Many Professionals Define Seven Types of Investment Risk

1. Inflation Risk 2. Interest Rate Risk 3. Business Risk 4. Credit Risk 5. Market Risk 6. Liquidity Risk 7. Portfolio Risk

1. INFLATION

Inflation risk could also be called long-term risk. Inflation erodes the purchasing power of the dollar and lowers the rate of return on investments. Inflation risk turns cash equivalent and fixed-income investments into high risk and low reward investments. Time usually favors an investor, but it can also work against them. The more time an investment must grow, the more time inflation must rise as well. Our investments need to grow at a higher rate than inflation.

For example, a person's cash equivalent and fixed-income investments are earning four percent, but they lose five percent of their value to inflation.

The outcome: that individual will have has less purchasing power at the end of a year than they had when they started. The novice investor seldom recognizes this loss due to inflation. Most investors probably look only at the interest earnings on their yearly statements. Few also consider the rate of inflation.

A person faces inflation risk with any investment that pays back a fixed dollar amount in the future with no change of growth of principal.

These types of investments would include Certificates of Deposit (CDs), bonds, money market account and fixed annuities that do not have a quarterly or yearly interest adjustment, which has the potential of matching the changes in inflation. Some types of investments in hard assets, such as real estate, art, or collectibles might rise with inflation. Of course, there are no guarantees of this. It was once popular to invest in precious metals because they were thought to keep pace our even outpace inflation. In recent years, fewer professionals tend to believe this. The stock market has the potential for growth, which can offset the loss in purchasing power of the dollar, but stocks can go both up and down. The investor is always wise to check out the stocks they are buying. In addition, most professionals recommend the positive investing approach when dealing with stocks. The positive investment approach means investing in products the investor knows and understands.



Protection Against Inflation

One can protect themselves against the risk of inflation by simply following three steps. These steps would include understanding inflation, alternatives and a balanced portfolio (proper asset allocation).

Understanding inflation is the first step. Most people have a rough understanding of the workings of inflation (what causes it and how it affects various investments and areas of the economy in different ways) so that educated decisions can be made.

Understanding inflation will help an investor distinguish between the investments that can reduce financial uncertainty and those that will only make an investor's problems worse.

Inflation does not shower its affection on any one particular investment field.

A key point to remember is that inflation does not shower its affection on any one type of investment field. There is no simple inflation hedge that will show profit because of inflation. One of the worst consequences of inflation is the chaos it creates in the economy and in the investment world. Because of inflation, nearly all investments go through extreme cycles of boom and bust. That is why so much investing must be done for the long term to really show a substantial yield.

This could be seen in October 1987. At the close of the market on Monday, October 19, 1987, stocks in Canada and most other countries were down about 40 percent from the highs they had established a few weeks earlier. Some stocks fared worse than others, of course. Some portfolio managers profited from the crash. Three years later, the average stock had regained its 1987 losses. The crash of 1987 appeared to have no lasting effects. However, if you asked the many people who lost their jobs, or the hundreds of securities firms that were forced into bankruptcy or the countless thousands that had planned on an early retirement, they may say that there were many lasting effects of the October 1987 stock market crash!

It has often been suggested that an investor should measure in an inflation hedge. Doing so is not so much a science, however, as it is an art. At one time, gold was considered a hedge against inflation, primarily because it was something the average person could understand (or so they thought). Gold represented money to most people.

In recent years, we have seen all precious metals as volatile as any other investment.



There really is no inflation hedge that is foolproof. The stock market, which was the supposed inflation hedge of the 1960’s, has seen downturns. The real estate market's boom of the late 1970’s and early to mid 1980’s which seemed to be providing an inflation hedge for many people, suddenly turned sour in late 1989. Bottom line: No investment will profit from every stage of an inflationary cycle. Over the long run, stocks do perform reasonably well as does most real estate. In the short run, continuous performance is difficult to sustain.

Investment Alternatives and Techniques

The second step is to become acquainted with the wide range of investment alternatives and techniques available to the investor. Few investments continually do poorly or continually do well. Most have difficulties as they respond to market conditions. As a result, investors need to realize that what did poorly last year may be doing well this year. Of course, the opposite can also be true (doing well last year and poor this year). Professional investors supposedly know how to read market trends allowing them to buy and sell to take advantage of good returns while avoiding poor returns. Realistically, reading market trends is like predicting the weather. It is more of an art than a science. The key word is "predicting.” Just like the weatherman is not always right, neither is the professional investor.

The best advice when it comes to investing is to make use of all the available data. The more we know about an investment, the more we are likely to profit. It is the adage: invest in stocks you know and understand.

Benefits of A Well-Balanced Portfolio

The final step in avoiding the risk of inflation is to construct a well-balanced portfolio so that an investor can forget (almost) about their investments. The idea is to be able to enjoy our life and be confident that our investments are protected. Our investments should profit no matter how inflation evolves and no matter how and when it ends. Of course, no investor should absolutely forget about their investments, regardless of how well they are doing. While most are designed for the long term, we still need to keep track of our money. A key consideration for an investor is that there is proper balance among several different investments.

During a time of inflation and high interest rates, tax deferral is more important for dollar investments than for any others, since high interest rates mean that dollar investments will be producing more taxable income. Thus, a device for deferring taxes will be especially valuable if it can be used to shelter assets denominated in dollars.



Diversification

A well-diversified portfolio is probably one thing every expert can agree upon. Diversification is a concept that is backed by a great deal of research and market experience. Diversification is the process of reducing risk within a portfolio. As the number of companies increase, the level of risk should decline.

In addition to the number of companies, a person also needs to diversify their assets, by purchasing a variety of stocks, bonds and real estate, if they so desire. To diversify correctly, a person would need to buy a variety of at least 20 different stocks of different companies in different industries. From a common sense standpoint, 20 stocks in 20 different technical companies is not diversification. Even though some may do well even if others are not, the general market risk is too like be considered diversification.

Mutual funds are sold with the idea of diversification. As the types of mutual funds become more specific, a person must keep aware of the diversification of their total portfolio.

Risk Reduction

The benefit diversification provides is risk reduction. Risk to investors can be defined as volatility of return or standard deviation. This refers to the possible variation of investment return. Investors would prefer returns that are relatively predictable and thus less volatile. Of course, investors also want returns that are high. Diversification eliminates much of the risk without reducing long-term returns. Understanding inflation, investment alternatives, and how to acquire a balanced and well-diversified portfolio may be the most intimidating aspects for an investor to overcome. It can be time consuming and difficult, but it is ultimately worth it.

MEASURING RISKS

Professional money managers seek the maximum return for a given level of risk, while also seeking the lowest risk for a given level of return. A rational investment strategy dictates that investment options be ranked according to risk. This means that risk should be measured and quantified.

Measuring some risks comes intuitively. Investors understand that an aggressive growth stock has more risk than that of a Treasury Bill or that the chances of being hit by lightening are higher than winning a lottery. We could safely say that all investors understand obvious risks and their counterbalance, the reward opportunity.



Unfortunately, the differences of investment risk are not so clearly stated or defined. For instance, which is a better buy given their levels of risk and return: Aggressive Growth or European equities?

An investor's decision is most often based on asset allocation models or mutual fund and/or sub-account investing because of their choice of provisionally managed investments.

ALPHA & BETA

The investment industry has devised measurements for each. They are known as:

1. Alpha (reward). 2. Beta (degree of risk).

1. Alpha

Alpha is an investor's expected return for the level of risk assumed. Beta measures the quantified risk over a given time period. In each case, there will be variance that is measured by the standard deviation. This anticipates the upside and downside potential at a given level of risk. By definition, standard deviation is the opportunity for gain versus the possibility of a loss at a given level of risk.

Alpha is important when measuring and comparing sub-accounts and money manager performance. The performance should be measured over a specified period and it should be measured and compared to its peers and industry averages.

2. Beta

The beta coefficient is one method of measuring risk. It relates the volatility of an investment to the market. The market, or measurement index, has a beta of 1.00.

Standard deviation is the opportunity for gain versus the possibility of a loss at a given level of risk.

Beta risk is an important consideration for professional money managers and investors alike because the effective use of diversification can reduce residual risk. Beta derivation is a straightforward concept. Most sub-account betas are accessible to investors through numerous industry research publications and ratings services.



Lifecycle Beta

Beta can also be a measure of risk for an investor's stage in the lifecycle and general attitude toward risk. There is no quantifiable measurement for either because both are subjective. It does not take a genius to figure out that preservation of capital is more important to older investors, while growth is normally more important to younger investors.

It is important for insurance agents and brokers, financial planners or whoever is discussing an investment portfolio with a client that they give them a realistic evaluation of the worst-case scenario.

Part of risk management is risk measurement. Several aspects of risk measurement have been discussed. Degree of risk was shown to be measured by variation between expected return and actual losses.

Probability of Loss Can Be Measured in Three Basic Ways

1. Frequency 2. Severity 3. Variation

1. Loss Frequency

It is important for risk managers, based on the past loss experience (frequency) of their firms or that of similar classes of risk exposures, to predict variation risk in future losses. The primary purpose is to help them decide what to do about various loss exposures.

Some losses may be found to be so infrequent that it would be uneconomical to try to deal with them. Some losses may be so frequent as to be regularly anticipated.

2. Severity

If properly carried out a risk manager can properly measure the risk to aid in suggesting the best way to treat the most important risks and possible losses.

3. Variation

With additional information about losses over a period of years, the trends and variations in losses and gains over a period of years can be estimated with more of an educated guess.



Measuring Risk Further

A probability distribution has been defined as a set of possible outcomes with a probability of occurrence attached to each outcome. If an investor is considering five different investments, there is five probability distributions; one for each of the five investment alternatives. For instance, if an investor was interested in T-bills, the rate of return is known for a certainty, no matter what the economy does to the interest rates. Thus, you could say that the T-bill has zero interest rate risk (it does have inflation risk).

No investment is risk free. Although, the T-bill may have zero interest rate risk, it still carries another kind of risk. When the T-bills mature, and reinvestment is required, the current interest rates may have declined. At this point, the portfolio's income will drop. This risk is called reinvestment rate risk. As the name implies, the risk is connected to declining interest rates. A lower earning interest rate means lower returns for the investor.

If the investor were considering corporate bonds, stocks, annuities, mutual funds or whatever, the return on the investment would not be known until the end of the holding period. Since their outcomes are not known with certainty, the investments can be defined as risky.

Probability Distributions May Be Either One of the Following

• Discrete

• Continuous.

A discrete probability distribution has a limited number of outcomes. There is only one possible value, or outcome, for the T-bills' rate of return, although for other investments there are alternative outcomes. Each outcome has a corresponding probability of occurrence.

If an investor can multiply each possible outcome by its probability of occurrence and then sum these products, they will have a weighted average of outcomes. The weights are the probabilities, and the weighted average is defined as the expected value. Since the outcomes are rates of return, the expected values are expected rates of return.

Expected Rate of Return

The expected rate of return on an investment or portfolio is simply the weighted average of the expected returns of the individual securities in the portfolio. Normally, investments with higher expected returns have larger standard deviations (more risk involved) than investments with smaller expected returns.



To better explain what standard deviation is, let's look at an example: let's say Investment A has a 30 percent expected rate of return and a standard deviation of 10 percent, while Investment M has an expected rate of return of 10 percent and a standard deviation of 5 percent. Which looks better? Which would you recommend?

If the returns of Investment A and Investment B are approximately normal, then Investment A would have a very small probability of a negative return despite its high standard of deviation.

While Investment B, with its lower standard deviation figure, would have a much higher probability of a loss. Therefore, to properly understand the implications of standard deviation as measures of the relative risks of investments whose returns are different, we need to standardize the standard deviation and calculate the risk per unit of return. This can be accomplished by using the coefficient of variation (CV), which is defined as the standard deviation divided by the expected value.

The Bottom Line

Investment B had more total risk per unit of expected return than Investment A. This means that one could debate that Investment B was riskier than Investment A, despite the fact the Investment A's standard of deviation was higher (10 percent versus 5 percent).

Maximum Possible & Probable Loss

Risk managers can divide potential losses into various categories of importance to their firm. Classifications may be established, such as those losses, which are high, moderate, or of slight importance. Estimates of maximum possible loss, the worst that can happen, and the maximum probable loss, the worst that is likely to happen are valuable measures.

Probably the most useful to risk managers is the concept of maximum probable loss because by using some actual or even hypothetical data, the probability that severe losses might occur can be observed and measured. Some extreme possibilities that are possible, but not likely, are disregarded in the estimate of maximum probable loss.

Living with Risk and Return

The concepts of risk and return have been analyzed as separate entities. I hope that most investors, as well as the agents selling to them, understand the positive correlation between risk and return. Increased risk should offer increased return. Decreased risks also mean decreased returns.



Rising Interest Rates Cause Falling Bond Prices

An investor may expect a safe return of five percent by purchasing risk-free investments such as short-term certificates of deposit. Increasing our expected return above five percent involves also increasing the investor's assumption of risk.

The relationship between risk and reward differs between investors and with the ever-changing business environment.

2. INTEREST RATE RISK

Interest rate risk applies to fixed-income investments such as bonds or CDs (Certificates of Deposit). Generally, the bonds of any organization have more interest rate risk the longer the maturity of the bond. This means a maturity risk premium, which is higher the longer the years to maturity, must be included in the required interest rate. The effect of maturity risk premiums is to raise interest rates on long-term bonds relative to those on short-term bonds.

Interest rate risk can be divided into two categories:

1. Value Risk 2. Reinvestment Rate Risk.

1. Value Risk

Interest rate fluctuations can severely affect bond values and certificate of deposit (CD) rates. Rising interest rates cause falling bond prices. Fixed-income investment unit values decrease periods of sharply rising interest rates. If an investor owns a bond and their market price goes down, it does not mean that they need to sell. If the investor bought the bond for fixed income and they still expect to receive the full face value at maturity, no money will be lost by holding them. The risk lies in the possibility of needing to sell before maturity. In such an event, a lower price than paid would be received. Therefore, a loss would occur.

Bond funds are especially vulnerable to value interest rate risk, because they have no maturity date. An ordinary bond, which has lost value due to rising interest rates, can be held until maturity, and the investor will receive the full face value - no money is lost. However, because bond funds do not have a maturity date, there is no promise of receiving the full value at maturity.



Mutual funds are priced at current market value of the securities held in the fund, which may or may not reveal or identify the depressed market price of certain or specific individual bonds held within the portfolio of the fund which may subject the investor to an uncontrolled depreciation in the value of his or her investment or an unrealized loss depending, of course, on whether or not the manager chooses to crystallize these losses by actually selling the affected security.

2. Reinvestment Rate Risk

If interest rates fall after an investor invests, they will be reinvesting the interest payments that they receive at a lower rate. Short-term bonds are highly exposed to reinvestment risk.

This means that when the investment matures, or if it is "called" before maturity, the investor's choices of reinvesting the principal could result in their earning a lower rate of interest. Therefore, while investing in short-term investments preserves a person's principal, the interest income provided by short-term investments varies from year to year, depending on reinvestment rates.

Call Risk

When an investment is "called" before maturity, it is termed Call Risk. Call risk is the risk that a bond (investment) will be called or bought back before maturity by the issuer on demand. Not all tax-free bonds are callable, but those that are may be called after interest rates have declined. Calling a bond allows the issuer to reissue the bonds at a lower interest rate. Normally the bonds are only called after the interest rates have declined. The investors then must reinvest their money at lower interest rates. This is very similar to what homeowners do when interest rates fall - they refinance their homes to take advantage of the lower interest rate.

Call Protection

Some bonds have call protection. This is a guarantee that a security cannot be bought back by the issuer until a specific amount of time has gone by. Treasury securities are usually noncallable.

3. BUSINESS RISK

Investors face business risk when they invest in such things as common stocks and corporate bonds. If an investor has common stock or corporate bonds in a certain corporation, this is the risk which faces an individual corporation from such diverse sources as management error, faulty products, poor financial planning, market mistakes and so on.



If the individual corporation starts to experience income statements in the "red", the investor's common stocks or corporate bonds may be in trouble. The most severe trouble may be when this individual corporation files bankruptcy. Why?

If an investor holds common stock, they are at the bottom of the list when it comes to repayment. The investor is behind Canada Customs and Revenue Agency, lawyers, banks, bondholders and preferred stockholders when it comes to getting any money back.

How can an investor avoid business risk? The best way is simply diversification. If stocks of individual companies are held, it is recommended that no less than 15 different stocks be purchased individually or through mutual funds. When an investor has a "cushion" of 14 other companies, experts say that the business risk of any one company is effectively diversified.

An investor's income can decline due to several reasons occurring naturally in the business environment. This is important to money managers when making individual securities investments. It is less important to investors who have hired money managers to analyze the risk of individual securities. It is important, however, for investors purchasing individual securities.

Business risk, also called diversifiable risk or unsystematic risk, can also be caused by such company-specific events as lawsuits, strikes, successful and unsuccessful marketing campaigns, and winning and losing major contracts. Again, since these occurrences are unique to an industry or firm, they are essentially random and can be compensated for through diversification. It cannot be overstated that an investor can diminish their business risk (diversifiable risk) by sending their investments to a variety of industries or firms - thus diversifying.

20 Types of Business Risk

A business risk is a future possibility that may prevent you from achieving a business goal. The risks facing a typical business are broad and include things that you can control such as your strategy and things beyond your control such as the global economy.

There is a strong relationship between risk and reward. It's generally impossible to achieve business gains without taking on at least some risk. Therefore, the purpose of risk management isn't to eliminate risk. In most cases, risk management seeks to optimize the risk-reward ratio within the bounds of the risk tolerance of your business. The following are common types of business risk.



1. Competitive Risk

The risk that your competition will gain advantages over you that prevent you from reaching your goals. For example, competitors that have a fundamentally cheaper cost base or a better product.

2. Economic Risk

The possibility that conditions in the economy will increase your costs or reduce your sales.

3. Operational Risk

The potential of failures related to the day-to-day operations of an organization such as a customer service process. Some definitions of operational risk claim that it is the result of insufficient or failed processes.

However, operational processes that are deemed to be complete and successful also generate risk.

4. Legal Risk

The chance that new regulations will disrupt your business or that you will incur expenses and losses due to a legal dispute.

5. Compliance Risk

The chance that you will break laws or regulations. In many cases, a business may fully intend to follow the law but ends up violating regulations due to oversights or errors.

6. Strategy Risk

The risks associated with a strategy.

7. Reputational Risk

Reputational risk is the chance of losses due to a declining reputation as a result of practices or incidents that are perceived as dishonest, disrespectful or incompetent. The term tends to be used to describe the risk of a serious loss of confidence in an organization rather than a minor decline in reputation.

8. Program Risk

The risks associated with a business program or portfolio of projects.



9. Project Risk

The risks associated with a project. Risk management of projects is a relatively mature discipline that is enshrined in major project management methodologies.

10. Innovation Risk

Risk that applies to innovative areas of your business such as product research. Such areas may require adapting your risk management practices to fast paced and relatively high risk activities.

11. Country Risk

Exposure to the conditions in the countries in which you operate such as political events and the economy.

12. Quality Risk

The potential that you will fail to meet your quality goals for your products, services and business practices.

13. Credit Risk

The risk that those who owe you money to fail to pay. For most businesses this is mostly related to accounts receivable risk.

14. Exchange Rate Risk

The risk that volatility in foreign exchange rates will impact the value of business transactions and assets. Many global businesses have high exposure to a basket of currencies that can add volatility to financial results such as operating margins.

15. Interest Rate Risk

The risk that changes to interest rates will disrupt your business. For example, interest rates may increase your cost of capital thus impacting your business model and profitability.

16. Taxation Risk

The potential for new tax laws or interpretations to result in higher than expected taxation. In some cases, new tax laws can completely disrupt the business model of an industry.

https://simplicable.com/new/country-risk

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17. Process Risk

The business risks associated with a process. Processes tend to be a focus of risk management as reducing risks in core business processes can often yield cost reductions and improved revenue.

18. Resource Risk

The chance that you will fail to meet business goals due to a lack of resources such as financing or the labor of skilled workers.

19. Political Risk

The potential for political events and outcomes to impede your business.

20. Seasonal Risk

A business with revenue that's concentrated in a single season such as a ski resort.

4. CREDIT RISK

Credit risk, also termed Default Risk, is the risk that the borrower cannot pay back the interest or principal they owe the investor. Therefore, corporate and municipal bonds are risk-rated by rating agencies. Investments with a lower credit rating pay a higher rate of interest because investors generally demand more interest to compensate for the possibility (risk) that the issuer may default. We see this higher rate usage in just about any type of loan where default of repayment is a possibility. Even mortgage loans and car loans impose higher rates for those with a higher risk of nonpayment.

Canadian Treasury securities or Canada Savings Bonds have no credit risk, thus they have some of the lowest interest rates on taxable securities in Canada. Treasury securities are free of credit risk because a person can be virtually certain that the federal government will pay interest on its bonds and will pay them off when they mature. For corporate bonds, the higher the bond is rated, and the lower its credit risk, the lower the interest rate charged.

The greater the credit risk, the higher the interest rate issuers charge. No one would invest in something that offered a high amount of risk and low returns.



5 Best Practices to Manage Credit Risk in Banking Sector

Over the recent years, the financial services sector has encountered challenges for several reasons, but many of those challenges can be linked to bad lending, poor risk management, or the lack of agility in adapting to changing economic scenarios.

Credit risk, in simple terms, is the uncertainty of bad debts, in case a borrower fails to meet his commitments in accordance with the agreed loan terms.

The primary aim of credit risk management is to take calculated exposures within defined parameters so that the overall process optimizes the bank’s risk-adjusted rate of return.

Since vulnerability to credit continues to be the prime risk factor for the financial industry worldwide, banks should take special initiatives in strategizing comprehensive measures to identify, monitor, and control the inherent risks in lending as best as they can.

The best practices outlined in this article address the issue of credit risk management in the following areas:

1. Setting up an ideal credit risk environment 2. Formulating a full proof credit-granting process 3. (Securing controls over credit risks 4. Intelligent recruitment of human resource, and 5. Incorporation of effective information system.

1. Setting up an Ideal Credit Risk Environment

The bank’s board of directors, in an ideal credit risk environment, should involve and take the responsibility of periodically reviewing the credit risk policies of their bank. The policy, as and when undertaken by the board, should clearly state the bank’s tolerance level for risks, and the interest rate spread it requires for taking such risks.

The top-level management is then obligated to implement the credit strategy approved by the board for classifying, measuring, monitoring and regulating the credit risk. Such policies should be religiously followed across the organizational line for individual as well as portfolio credits.

Banks should periodically monitor the inherent credit risks in all its products and services. For new launches, it should identify risks in advance and price-them out by ensuring that adequate risk management procedures are initiated before the product is introduced.



2. Formulating a Full Proof Credit Granting Process

It is essential for banks to operate within well-defined credit criteria. These criteria should clearly lay down the bank’s target market, the borrower’s credential requirements, purpose and structure of credit, and the source of repayment.

Financial institutions should set an overall credit limit for all individual borrowers, as well as for connected counterparties, as specified in the credit policy.

Banks should also explicitly define its approval guidelines for new credits, renewal, refinancing, and premature terminations. Deviation in guidelines shouldn’t be entertained without the recommendation of the board.

3. Securing Control Over Credit Risks

Banks must establish a process for continuous review of credit risk management strategies. Results of such assessments should be forwarded directly to the board of directors.

The reviews are intended to provide valuable insights on whether the bank’s credit granting functions are being accurately managed within the defined standards and limits.

Banks must enforce an internal control mechanism to make sure that exceptions of policies, limits, and procedures are communicated to the appropriate authority in time.

There should be a streamlined system in place for early detection of fraudulent activities, and for corrective action on deteriorating credits.

4. Intelligent Recruitment of Human Resource

It is also a responsibility of the management to ensure that enough and competent resources are allocated to control and manage the credit risks.

Credit managers should:

• Have a comprehensive perception of the risks associated with the bank’s credit activities.

• Be capable of understanding relevant factors and conditions which can directly or indirectly affect the credit quality and risk profile of the institution.

• Immediately report a change in the risk profile or credit portfolio to the concerned authority for consideration.



The bank management should consistently organize credit training programs to equip its personnel with adequate knowledge about the institution’s credit standards and culture.

5. Incorporation of Effective Information System

Banking institutions must have an information system in place to effectively manage the inherent credit risks in its activities.

The information system should enable the bank to:

• Use analytical techniques to maintain a database for credit research. • Report high exposures. • Track the status and account performance. • Monitor and control limits.

Financial service providers should tally its credit risks with the overall spread of an account relationship. Credits should be priced in such a way that, together with other revenues earned from an account, it would compensate all the associated costs and risks incurred by the institution.

5. MARKET RISK

Non-diversifiable Risk or Systematic Risk

Market risk is a type of risk that remains even in a diversified portfolio. Market risk pertains to the factors that affect the economy. Since economy factors can be good or bad, it can affect investments negatively or positively. This, in effect, causes investments to change in value regardless of the fundamentals of individual investments. The market value of an investment can vary substantially over short periods. Market risk lessens over time.

Market risk, or non-diversifiable risk, comes from external events such as war, inflation, recession and high interest rates, which have an impact on all the economy. Since it is "all" affected at once by these factors, market risk cannot be eliminated by diversification. It can be reduced, but not eliminated.

Market risk can also be called systematic risk because it shows the degree to which a stock moves systematically with other stocks.

An investor cannot control market risk. An investor could not have stopped the stock market crash of 2008, which is an example of stock market risk. An investor could not have stopped the economic downturn of the early 1990s, which is an example of market or economic risk for real estate investments.



What is Total Risk?

Total risk refers to how risky an asset is, that is held in isolation. This would apply if an investor held only stocks from Air Canada or Nortel. The stock's risk is measured by the dispersion of returns on its expected returns. The greater the dispersion, the higher the chances that the return will be below the expected return, which in turn means the individual stock holds a greater risk.

However, when an investor practices asset allocation diversification total risk can be reduced. When an investor holds many different types of stocks in their portfolio, then the importance of an individual stock becomes less risky. A stock or asset that would be considered risky by itself (held in isolation) may not be risky at all, if it is in a diversified portfolio.

In other words, the risk of one of the stocks is offset by the gains of another. In this case, the relevant risk of each stock is its market risk, which measures the stock's contribution to the overall volatility of the portfolio.

With this in mind, we can see a clear picture of how the greater the impact of a stock on the overall riskiness of a portfolio, the higher the market risk of the stock. A stock's risk is affected by its total risk, but it is also affected by the connection of its returns with the returns on a portfolio of stocks.

Total and market risk affect all types of investments such as securities, stocks and bonds, real estate, precious metals, corporate capital investments and so on.

What Are the Primary Sources of Market Risk?

Market risk is the risk of loss due to the factors that affect an entire market or asset class. Market risk is also known as undiversifiable risk because it affects all asset classes and is unpredictable. An investor can only mitigate this type of risk by hedging a portfolio. There are four primary sources of risk that affect the overall market: interest rate risk, equity price risk, foreign exchange risk and commodity risk.

Interest Rate Risk

Interest rate risk is the risk of increased volatility due to a change of interest rates. There are different types of risk exposures that can arise when there is a change of interest rates, such as basis risk, options risk, term structure risk and repricing risk.

Basis risk is a component due to possible changes in spreads when interest rates are fluctuating. Basis risk arises when there are changes in the spread between different markets' interest rates.



Equity Price Risk

Equity price risk is the risk that arises from security price volatility – the risk of a decline in the value of a security or a portfolio. Equity price risk can be either systematic or unsystematic risk. Unsystematic risk can be mitigated through diversification, whereas systematic cannot be. In a global economic crisis, equity price risk is systematic because it affects multiple asset classes.

A portfolio can only be hedged against this risk. For example, if an investor is invested in multiple assets that represent an index, the investor can hedge against equity price risk by buying put options in the index exchange-traded fund.

Foreign Exchange Risk

Currency risk, or foreign exchange risk, is a form of risk that arises when there is volatility in currency exchange rates. Global firms may be exposed to currency risk when conducting business due to imperfect hedges.

For example, suppose a US investor has investments in China. The realized return will be affected when exchanging the two currencies. Assume the investor has a realized 50% return on investment in China, but the Chinese yuan depreciates 20% against the U.S. dollar. Due to the change in currencies, the investor will only have a 30% return. This risk can be mitigated by hedging with currency exchange-traded funds.

Commodity Risk

Commodity price risk is the volatility in market price due to price fluctuation of a commodity. Commodity risk affects various sectors of the market, such as airlines and casino gaming. A commodity's price is affected by politics, seasonal changes, technology and current market conditions.

For example, suppose there is an oversupply of crude oil, which has caused oil prices to fall every day over the past six months. A company that is heavily invested in oil drilling wells faces commodity price risk. The company's profit margin will fall as well since it is still operating at the same cost, but the prices of crude oil are falling. Its profits will decrease. The company could use futures or options to hedge this risk and minimize the uncertainty of oil prices.

6. LIQUIDITY RISK

Liquidity risk refers to the ability to "cash out" an investment. The risk of cashing out refers to the ability to sell the investment quickly without losing principal.



An investor may have an appraised value of their home or stamp collection, but that won't put cash in their pocket if they cannot find a buyer who is willing to pay the appraised price. Liquidity risk affects investments that do not have active secondary markets and investments that are in very volatile or cyclical market, such as real estate.

Examples of Liquidity Risk

Liquidity risk is the potential that an entity will be unable to acquire the cash required to meet short or intermediate term obligations. In many cases, capital is locked up in assets that are difficult to convert to cash when it is required to pay current bills.

1. Accounts Receivable

An IT consulting firm relies on reasonably timely customer payments in order to meet quarterly cash needs. A dispute with a large customer results in a sudden decline in cash flows and the firm misses a payroll payment. This results in compliance issues, fines and a severe decline in reputation and employee satisfaction.

2. Bank Deposits

Banks don't have the cash that would be required if all customers were to withdraw their deposits all at once. If economic conditions cause many withdrawals, banks may require a large amount of cash in a short period of time.

3. Lines of Credit

In addition to deposits, unused space in lines of credit can quickly drain the liquidity of banks.

4. Debt Terms

A manufacturing company has a small reserve of cash and a large unused line of credit. The firm experiences a period of rapidly declining prices due to industry oversupply. They quickly run out of cash as their operating margins turn negative. The line of credit becomes unavailable due to their poor financial metrics. The firm starts to miss payments and suppliers stop supplying them with essential inputs. The business goes into a downward spiral and is quickly bankrupt.



5. Marketable Securities

An investor purchases a low volume small cap stock. The investor suddenly requires cash due to a personal emergency but has trouble selling the stock due to the low volume. The investor must set the price surprisingly low before their order finally fills. This results in a loss. If the investor had owned a high volume stock it could have been sold instantly at a market price with a low bid-ask spread.

6. Assets

An investor who has all their net worth in real estate generates cash by selling properties on a regular basis at a profit and purchasing new ones. This works for the investor while the market is hot.

When market conditions change, houses are difficult to sell, and it takes over a year to complete a single sale. The investor is short on cash and must sell a few properties at exceptionally low prices to attract buyers in a down market.

4 Principles for More Robust Liquidity Risk Management

Here are the four most essential principles of robust liquidity risk management that should be considered by banks:

1. Identify Liquidity Risks Early

A liquidity deficit at even a single branch or institution has system-wide repercussions, so it’s paramount that your bank be prepared before a shortfall occurs. This means your bank needs to have a rigorous process for identifying and measuring liquidity risk. Your liquidity management process should include a forward-looking framework to project future cash flows from assets, liabilities and items not on your balance sheet.

This framework should include:

• The ability to conduct risk analysis on extreme, hypothetical situations • The maintenance of liquid assets to serve as a cushion in case of a

possible shortfall

2. Monitor & Control Liquidity Regularly

Once you’ve identified and forecasted your bank’s liquidity risk, you need to actively monitor and control any risk exposures or funding needs.



Depending on the size and scope of your bank, this monitoring needs to account for multiple legal entities, business lines and international currencies. Of course, you must also remember to account for any banking compliance regulations that might limit the transferability of your liquid assets. Ensure that your liquidity risk monitoring and control tools include the following indicators and metrics:

• Global liquidity indicators • Business-specific liquidity indicators • Advanced cash flow forecasting • All relevant regulatory ratios

3. Conduct Scheduled Stress Tests

Just like any professional facility must practice for fire drills or emergency procedures, your bank needs to conduct regular financial stress tests to anticipate different potential liquidity shortfalls. Your stress tests should include both short-term and long-term scenarios that identify sources of liquidity strain and that ensure all exposures align with your established liquidity risk tolerance. Confirm that your regularly scheduled stress tests include the following scenarios:

• Institution-specific strains • Market-wide stress scenarios of individual variables • Market-wide stress scenarios of multiple, combined variables

4. Create A Contingency Plan

Using the results of your stress tests, adjust your liquidity risk management strategies accordingly. Then, use these new policies and positions to develop a formal contingency funding plan (CFP) that clearly articulates your bank’s plan for overcoming liquidity shortfalls in various emergency situations. A robust Contingency Plan should:

• Outline policies for managing various stress environments • Delegate clear lines of responsibility • Establish escalation procedures • Be regularly tested and updated

In today’s complex financial markets and ever-changing compliance environment, liquidity risk management is more difficult than ever.



However, with these four principles to guide your liquidity management efforts, your bank navigates these shifting tides with greater security and confidence for the future.

7. PORTFOLIO RISK

Market risk refers to the market. An investor cannot control market risk. Market and total risk could be reduced by diversification. Then there is portfolio risk. Portfolio risk is the expected return on a portfolio. This type of risk can be measured.

The expected return on a portfolio is the weighted average of the expected return of the individual investments in the portfolio. The realized rate of return on the investment may be seen a year or so later. What an investor expects and what they receive (realize) are two different things.

Where the return portion of the investment can be measured, the standard deviation of a portfolio is normally not a weighted average of the standard deviations of the individual investments in the portfolio. Each stock's contributions to the portfolio's standard deviation are not either.

Theoretically, then, it is possible to combine two stocks that are individually risky, as measured by the standard deviations, and to form from these risky investments a portfolio that is completely free of risk.

Covariance & Correlation Coefficient

The riskiness of a portfolio is measured by the standard deviation of its return distribution.

Two keys concepts in portfolio analysis are:

1. Covariance 2. Correlation coefficient.

1. Covariance is a measure that reflects both the variance (or volatility) of a stock's returns and the tendency of those returns to move up or down at the same time other stocks move up or down.

For example, the covariance between Stocks A and B tells us whether the returns of the two stocks tend to rise and fall together and how large those movements tend to be. If the covariance turns out to be zero, this indicates that there is no relationship between the variables. The variables are independent.



Since it is difficult to interpret the magnitude of the covariance term, the correlation coefficient is often used to measures the degree of covariance movement between two variables.

2. The correlation coefficient standardizes the covariance by dividing using a product term. This facilitates comparisons by putting things on a similar scale.

Efficient Portfolios

Of course, a person would want to select a portfolio design that is efficient. This would be defined as a portfolio, which provides the highest expected return for any degree of risk or the lowest degree of risk for any expected return.

For example, let us assume that we have Security A and Security B and we have a specific amount of money to invest. We can allocate our funds between the securities in any portion.

Security A has an expected rate of return of 5% and a standard deviation of return of 4%. Security B has an expected rate of return of 8% and a standard deviation of return of 10%. This means that Security A has an expected rate of return of 5% but could deviate (swerve) 4% up or down. The investor could end up with a rate of return at 9% or as low as 1%. Security B has an expected rate of return of 8% but could deviate (swerve) 10% up or down. The investor could end up with a rate of return as high as 18% or as low as -2%.

How would we set up our asset allocation or our portfolio for the most efficient use? This would depend upon what age the investor is and what they expect from their portfolio.

ASSET ALLOCATION

Asset allocation is the process of deciding where to invest. Most people do understand diversification, so asset allocation entails deciding which portion of the available investment funds go to which investment. This might include such things as annuities, stocks, mutual funds or real estate, to name a few. Each category of investment may be further divided.

For example, the portion that a person may want to invest in stocks would normally be divided between directly owned stocks and stock mutual funds. Within the stock mutual fund, a person must decide if they want to invest in higher risk funds or conservative funds, thus another layer with each investment made.



A person can make the job of asset allocation very hard if they chose to. A person can consider many different and potentially volatile factors in deciding how to invest their money, including stock market conditions, interest rates, economic prospects, tax regulations, and the person's own personal finances. This is one big reason why people do not pay attention to asset allocation. They do not want to take the time to look at the big picture. Normally, people tend to focus on one investment such as stock mutual funds, a municipal fund or some other investment of interest to them. There is a risk involved with not paying enough attention to asset allocation: there may be no long-term investment plan. A person's investment plan could be inappropriately allocated. In these instances, a person may not find out until it is too late. The other extreme is the person who is so obsessed with all the expert opinions that they move their investments all over the place and too often. This has been shown to also be an inappropriate allocation.

Permanent Portfolio Structure

A permanent portfolio structure is maintained over a long period with only minor changes; sometimes no change at all is made. A person should decide if they are a conservative, moderate or aggressive investor before establishing a permanent or nearly permanent investment strategy. Once a person has decided, there really is no reason to vary the investments. It has been shown that people who keep their investments relatively stable in a mixture of investment vehicles do very well over a long period.

This does not mean that a person should never make any changes. It only means that a person should not make rapid or frequent changes to their portfolio.

Guidelines for Asset Allocation

Investors who like to invest in extremes may think they are well diversified. Even so, they may be overlooking some kinds of investments that may help them achieve investment success. An investor should decide how much of their total investments they wish to invest in each of the three primary categories (stocks, interest earning investments and real estate). Not everyone will want to invest in all three categories, but for the broadest diversification, it would be advised to do so.

For younger and/or middle age people, they should weigh their investments in favor of stocks and real estate if they so wish.

This is because these investments have the best chance of beating inflation risk and producing long-term returns. A portion of the portfolio should be allocated so some of the portfolio remains conservatively invested.



People who are within about ten years of retirement should begin gradual shifts to more conservative investments. This decreases their market risk since they will need their money sooner than a younger investor and would be subject to market losses. Shifting a pre-retiree's investments to more conservative "safe" investments lessens the risk of being caught in a stock market downturn or a real estate slump.

For people who are already retired, the amount that is in riskier investments depends on how much they rely on their money to live on. If retirees need this money to live on, they may require investments that yield current income either with interest earning securities or dividend paying stocks. It may be wise for a person not to neglect stocks because they may need capital appreciation to fund a long retirement. Many retirees find that they have time to devote to the stock market and do quite well.

EXPECTED RETURN

The expected rate of return on a portfolio or combination of assets is simply the weighted average of the expected returns of the individual securities in the portfolio. Generally, an asset held as part of a portfolio is less risky than the same asset held in isolation. This is not so hard to understand. An asset that would be considered relatively risky if held in isolation may not be risky at all, if it is held in a well diversified portfolio. In this instance, considering risk in a portfolio could completely change a decision based on an analysis of total risk.

How Much Return is Required to Compensate for a Given Amount of Risk?

As we have determined, the riskiness of a portfolio is measured by its standard deviation of returns. This is generally less than the average risk of the individual assets within the portfolio. Since investors should and normally do hold portfolios of securities, it is reasonable to consider the riskiness of any security in terms of its contribution to the riskiness of a portfolio rather than in terms of the risk for a singular security held in isolation. Capital Asset Pricing Model (CAPM) specifies the relationship between risk and required rates of return on assets when they are held in well-diversified portfolios.

TREATING RISK

We have discussed the identification of risk and how to measure risk. We now need to discuss the treatment of risk and/or the administration of risk. A pitfall that some people fall into is assuming that there is a single method of treatment in the solution of risk. It is much more common to find all or at least several techniques used together to provide the best solutions for meeting the financial problems of risk.



Two Basic Methods to Treat Risk

There are two basic methods of treating risk:

1. Risk control in order to minimize losses. 2. Risk financing in order to reduce the costs of those losses that do occur.

In just about every case, it is not merely which to choose from (risk control or risk financing). Good risk management requires that both be used in methods of treating risk.

1. Risk Control

Risk control involves several alternatives. These alternatives are not limited to using just one. The goal is the proper choices, using all methods, which results in benefits that exceed the costs. Many associations use all or most of the techniques in order to best handle the diverse types of risk.

The alternatives include:

A. Risk avoidance. B. Separation, diversification, or combination of loss exposures. C. Loss prevention and reduction. D. Some non-insurance transfer loss.

2. Risk Financing

Risk financing also includes many alternatives that can be used separately or in combination with one another and with the previously identified risk control measures.

Financing methods are subdivided into two different categories:

1. Risk retention 2. Risk transfer

1. Risk retention helps provide different types of funding when paying for losses, absorption in expenses, special reserves, funds, deductibles, self-insurance and captive insurers. Insurance is the most common type of risk transfer, but some non-insurance transfers of risk and credit mechanisms are also useful.



RISK CONTROL ALTERNATIVES

In each of the alternatives, the primary goal is to achieve the purpose of minimizing losses that might occur to asset and income.

1. Risk Avoidance

This is probably the most obvious choice - avoid risks entirely, at least to the extent possible. Some types of risk are either not assumed or are abandoned altogether. For instance, a person could choose not to buy a home in order to avoid the risk of losing the home value through the peril of fire or real estate declines. Some risk must be assumed simply because we are alive.

It would be impossible to avoid all risks entirely. Financial risks can be avoided to some extent.

What usually happens, however, is that one risk is simply traded for another. For example, the person who is afraid of stock market risks may never invest anywhere at all. Therefore, they have traded the risk of a market downturn for the risk of poverty in their retirement years. That same person could have saved through another vehicle and avoided stock market risk while still saving for their retirement years. Risk avoidance is a common factor for most people when they invest. They avoid certain stocks, but purchase others. They avoid certain life activities, such as skydiving, but participate in others, such as water sports. Even deciding where to live can involve risk avoidance.

Most people buy homes in areas they consider safe. Total avoidance of risk is no practical solution to the many risks that are involved in normal day-to-day life. Some unusual risks with a high chance of loss can be avoided, but realistically the avoidance of risk is only an alternative about a restricted number of economic risks. Some risks may be impossible to avoid. Others may not be economically desirable, either because the benefits outweigh the costs or because avoiding one risk may create another. For all avoidable risks, other solutions must be considered.

2. Combination, Segregation & Diversification

The combining of exposures to loss is a common method of risk control. This method broadens the units of exposure and may aid in predicting future losses. Combining risks may spread the risk and create more stability in loss experience. This can be seen when combining singular investments that may be rated very aggressive or "risky" into a portfolio that equalizes them out, thus their risk rating may go down. Combination is a basic principle of insurance and self-insurance and it may be used in many other business situations.



Generally, the combination risk reducer process must be in combination or conjunction with other methods. For instance, for the combination method to be most effective, it should be used in conjunction with segregation and diversification or with other methods of risk financing. Just combining exposures is not the most effective way to reduce risk. In some cases, it may increase risk more than decrease it if the added exposures are more concentrated or variable than the previous exposures.

Segregation is the separation or dispersion of loss exposures. It is often an effective way of limiting the severity of loss by reducing the concentration of exposures.

Diversification uses different types of loss exposures as opposed to having only one type in order to improve one predictability. When assets are duplicated at different locations, the diversification technique is being used. Investing money into different types of investments is a way diversifying.

3. Loss Prevention & Reduction

Loss Prevention and Loss reduction could be considered separately, but because they are so closely related, we will discuss them as one.

Loss prevention may involve the elimination of the chance of loss and thus risk. More often, a reduction in the probability of loss is accomplished. Loss reduction has the goal of reducing the severity of loss, which includes the steps taken to accomplish this either before or after a loss.

The techniques used to help prevent or reduce loss are often logical. This is important since losses are rarely completely taken care of by just one method.

Preventing or reducing risk makes sense if it can be done for a reasonable cost in relation to its potential benefits. If human life were at stake, cost may become secondary.

Loss prevention and loss reduction is not the same thing as risk reduction. The risk or uncertainty of variable losses may still be the same, while the chance of decreasing loss or value is reduced. There may be a reduction of the conditions increasing the ratio of the likelihood of hazards to the cause of loss.

Much more could be said about loss prevention and loss reduction because this applies to so many fields including insurance agents, financial planners, brokers, consultants, insurers and insureds.



4. Non-insurance Transfers

Non-insurance transfers are affected by means of a contract, other than insurance, in which one party transfers to another the legal responsibility for property or employee losses. A method of risk financing transfers the financial burden of the transferor.

Subcontracting is one example of non-insurance transfer. When a company wants to build a building, they subcontract the electrical, plumbing, drywall and framing to outside companies. Those companies are financially responsible for the injuries those employees may face on that job, thus the financial burden or risk of loss is transferred or subcontracted out to another company.

Licensing is another example of non-insurance transfer. Under licensing contracts, a manufacturer that does not want to produce or sell certain goods can transfer some of the responsibilities. The manufacturer would receive only a royalty or fee for licensing others to do the work. The licensees would have the responsibility for injuries to their own employees.

RISK FINANCING ALTERNATIVES

Using methods of risk control in most cases only lessens the loss. One exception to that is risk avoidance in which the probability of loss or risk is eliminated. All the other methods of risk control still incur losses. Because of this, some additional choices are necessary in deciding how to pay for them. The two major types of risk financing will explain these choices in methods of risk financing: risk retention and risk transfer.

Risk Retention

If a certain risk has not been avoided, a person may decide to keep it. This is called risk retention or risk assumption. The residual risk must in some way be paid for.

There are five basic methods for paying for the residual risk:

1. Absorption in operating expenses, 2. Funding and reserves, 3. Deductibles and excess plans, 4. Self insurance, and 5. Captive insurance.

Lack of planning is probably the way most pure risks are retained. Some risks are retained because the existence or importance of the risks are not known.



Lack of knowledge or the inability to reach the right decision even with accurate knowledge may result in assumption or retention of risks. The information a person may require may not be available or the information may be available but not used. We often see others take risks that we ourselves would not be willing to take. Perhaps our neighbors are willing to own a home, but not willing to purchase fire insurance. Perhaps someone we know is willing to build his or her home on a site with poor drainage.

Whatever the peril, some will be willing to accept risk while others will not. Unplanned retention of risk may also result from unintentional, irrational action or from passive behavior due to a lack of thought, laziness or lack of interest in discovering the possibility of loss.

The important risks that people face day to day that could cause a financial hardship are the risks that must be paid for in some way. This is planned risk retention and is one method for risk retention. Planned risk retention happens when it is the result of purposeful, conscious, intentional and active behavior.

We could ask ourselves what reasons are there for using risk retention?

The reasons are simple:

• The necessity.

• Control or convenience.

• Cost.

Some pure risks can only be financed by retention. The risks are knowingly retained by necessity and are impossible to transfer. A certain market for insurance may temporarily be unavailable because there is a high probability for loss or a bad experience of loss. If this is the case, retention is necessary until the competitive world markets adjust permitting risk transfer.

Retention of risks may be used because individuals or businesses want the control and/or convenience of paying for losses themselves. Regardless of cost comparisons, some may want to have the benefits of direct and complete control.

A major consideration of risk retention is the cost. A comparison of the cost involved in each alternative method of financing losses is necessary. For instance, how much would it cost to insure a building for earthquakes verses building the building to withstand an earthquake? Another consideration is loss frequency and severity. All costs of the various alternatives, including indirect and direct costs are needed for fair comparisons.



Risk Transfer

Risks and losses that cannot be retained by individuals and businesses may be some of the most important to insure against. The primary method for consideration is the transfer of as much as possible of the unpredictability (the loss) to someone else.

Three ways or methods are possible:

1. Credit arrangements 2. Some non-insurance transfers 3. Insurance

1. Credit Arrangements

The use of credit arrangements or contracts to pay for losses may be considered as one way to transfer risk. However, borrowing money usually has another purpose, such as financing homes or business expansions. Since credit is always limited, it seems generally unwise to use credit for relatively unpredictable needs. Pure risks, especially for larger and infrequent loss are difficult to handle by borrowing after the need arises. In fact, a person may be adding the additional risk of not being able to obtain credit. It would generally be wiser to transfer these risks to others.

2. Non-insurance Transfers

Several other types of non-insurance transfers may transfer risks to others. A hedging contract is one method of transferring some speculative (loss or gain) risks. Sometimes this balancing of possible profit and loss through two offsetting contracts is called neutralization. This method cannot be used for pure risk, which involves no possibility of gain. Under neutralization or a hedging contract, there must be two possibilities: loss or gain.

Another method is the hold-harmless agreement. Most non-insurance transfers for risk financing deal with liability risks and the hold-harmless agreement is the best example of this. In this contract clause, the transferee agrees to hold the transferor harmless in the case of legal liability to others. The transferee agrees to pay claimants or to repay such losses if they fall on the transferor. If the transferee is unable to pay the losses, the ultimate responsibility remains with the transferor.

There are several types of legal contracts that commonly use the hold-harmless agreements. In lease contracts, for example, a wide variety of legal responsibilities are transferred from one party to another through hold-harmless agreements.



3. Insurance

Insurance is the most common type of risk transfer method used. A definition of insurance may be developed from several viewpoints:

• Economic

• Legal

• Business

• Social

• Mathematical

No matter which viewpoint is used, a full interpretation should include both a statement of its objective as well as the technique by which its purpose is achieved.

When we enter the field of insurance as a means of transferring risk, multiple types of risk transfer must be considered. We have primarily considered investment risk so far, but insurance transfer deals with virtually every type of common-day activities and the risks associated with them. Insurance covers our health, our homes, our motor vehicles, our liability to others, and virtually anything else one can dream up.

In fact, some very unusual policies have been written for people who are willing to pay the premiums.

Insurance companies, who assume our every day risks, employ actuaries. These men and women determine whether an insurance company is willing (from an economical standpoint) to assume the risks of another person or entity. It is their job to predict what the possible losses and gains are for the insurance company based on the facts. Sometimes there are few facts from which to make these predictions, especially if the field of insurance is new.

In simple terms, insurance is merely the transfer of risk from an individual or a business to the insurance company. With that transfer of risk, transfer of a possible loss also happens. If enough people or businesses are interested in transferring a particular risk, the cost of doing so becomes relatively inexpensive. That is why we see life insurance policies (which insure against premature death) so affordable.

Lots of people buy the policies, so the insurance company can offer affordable rates. Of course, competition also has some bearing on cost. When lots of people want something, the field becomes competitive.



When lots of people or businesses wish to insure the same risk, the role of the insurance company changes. While they do assume the individual risk, as a group risk, the danger is not longer as great. This group risk causes the science of probability to change. The probability laws of large numbers now apply. It is much easier to predict losses for a large group, but much harder to do so for an individual. Since the insurance company does not need to know precisely who will suffer the loss, they can predict their personal losses (as the insurer) for the group. Actuaries are surprisingly accurate at determining how many out of the group of insured will experience losses. From these figures, the insurance companies can set their premium rates that will provide the funds necessary to meet expected losses, plus the expenses incident to the conduct of business.

Everyone wins. The individuals might be able to completely shift the risk, and the insurance company, while if risk, makes a profit.

Even though premium rates can be developed that are very accurate, it would be unusual for them to be "on the mark.” Inevitably, the number of losses that do happen will be slightly above or below the predictions. Insurance companies know this and hedge for the possible higher losses. The same is true for investments. The earnings may be higher or lower than expected. While this affects individuals who invest, it also affects the insurance companies. They, too, invest. They invest the premium dollars as part of their hedge against higher than anticipated losses. We have sometimes seen insurance companies who were not as competent as they needed to be.

Law of Large Numbers

Insurance companies use the "law of large numbers" to predict their losses. It is true that the use of insurance reduces the risk. It may be difficult to understand why a pooling of the risks would reduce them, but this is the case. The law of large numbers is often referred to as the law of averages. Although it is called a "law", it is an entire branch of mathematics.

In the 17th century, European mathematicians were constructing crude mortality tables. From these, it was discovered that the percentage of male and female deaths among each year's births tended to be constant if enough numbers of births and deaths were tabulated. It was Denis Poisson, in the 19th century that named these tabulations the law of large numbers.

Why would individual risk be higher than group risk? The answer lies in the quantity of participants. The law of large numbers, or the law of averages, is based on the regularity of events. What seems random when it happens to an individual could be predicted when put in the context of a group.



While group predictions cannot say who will experience the loss, they can say that it will happen to someone within the group. So, the only reason an individual cannot say what will happen to them personally is because they do not have enough mathematical information. To gain this information, they must become part of the group. Again, this will not tell the individual whether they personally will be affected, only that someone within the group will be.

What appears to be chance, results with surprising regularity as the number of observations increase.

We see this every day on the nightly news. We just do not recognize it as the law of large numbers, sometimes called the laws of probability. Not only insurance companies use these mathematical statistics. Gambling establishments know these laws well.

They know with surprising accuracy how many people will win and how many will loose. They just do not know who the winners and losers will be.

The law of large numbers is the basis of all types of insurance, including health, disability, auto, home and liability. This law of large numbers changes the impossibility of predicting life events for one individual, to surprising accuracy for predicting life events for a large group. Insurance companies are perhaps the best score keepers of all. They know approximately how many houses will burn each year; how many deaths and at what ages will occur, how many people will die in auto accidents over the Victoria Day holiday weekend, and how many people will be permanently injured in job related accidents. If an insurance company insures it, they know the statistics.

Insurance companies want to insure enough quantities of people to minimize their risk. That brings in competition. It is important to each insurance company to bring in the number of policies necessary to minimize their losses. To bring in enough quantities, they must be competitive. This brings consumers better and wider choices.

Of course, statistics do eliminate risk for the insurance companies. It is impossible to achieve an infinite number of exposure units, so there will always be some margin for error. In addition, statistics are not perfect. It is possible to have wrong "facts.” It is also possible to misread the available information or to have too little information for a factual observance. An actuary was once quoted as saying that they initially had to underwrite nursing home policies with a crystal ball. Why? They had too little information available to know the outcome of their profits and losses.



Since risk diminishes with larger numbers and insurance seems so logical a method, one might wonder why all uncertainties are not combined in one big insurance pool to virtually eliminate risk. Unfortunately, it is not quite that simple.

For an Insurance Company to Operate Successfully, Several Things Are Needed:

1. A large group of homogeneous exposure units. 2. The loss produced by the peril must be definite. 3. The occurrence of the loss in individual cases must be accidental or

fortuitous (not purposely done, such as arson). 4. The potential loss must be large enough to cause a hardship. 5. The cost of the insurance must be within the means of large numbers of

people 6. The chance of loss must be calculable. 7. The peril must be unlikely to produce loss to lots of people

simultaneously.

1. Homogeneous Exposure Units

Let us look at these points individually. The first one, a large group of homogeneous exposure units, means it is essential that many exposures be similar, though not necessarily identical. If there were not enough policyholders facing the same peril, then not enough policies would be sold. If not enough were sold; the insurance company could not offer premiums at a price that consumers would buy. In life insurance policies, for example, many people are needed in differing age, health and occupation classifications. This allows the insurance company to spread out their potential risk. While some people will die and collect benefits, more will live to pay additional premiums to the company.

2. Loss Produced by The Peril Must Be Definite

The second point, the loss produced by the peril must be definite, which means it must be difficult to counterfeit. Death is probably the best peril because it is difficult to counterfeit death (although it is sometimes attempted). As we know, it is common for people to try to collect from insurance companies by fraudulent means. Disability insurance is now subject to strict underwriting because of past problems with adverse experience. In other words, they lost too much money to disability claims.



3. Occurrence of the Loss Must Be Accidental or Fortuitous

The third point, the occurrence of the loss must be accidental or fortuitous, means it must be an accidental unexpected loss. The loss should be beyond the control of the insured. Purposely setting fire to the insured’s' home is not unexpected. If the homeowner sets a match to his or her house, he or she fully expects it to burn down!

In some types of insurance, certain happenings are not covered because they are considered anticipated losses. For example, under mercantile theft insurance, shoplifting losses are not covered because they are considered part of the business; they are anticipated losses. In credit insurance, bad debt losses are not covered; they are anticipated losses for that line of business. Life insurance does not actually cover death, because everyone is expected to die at some point. Rather, life insurance covers premature death, because the exact point of death cannot be determined.

4. The Loss Must Be Large Enough to Actually Cause A Hardship

The fourth point, the loss must be large enough to cause a hardship, means the loss must cause the insured economic stress. Some types of loss are simply too small to be worth the time, effort and expense to set down an insurance contract. Remember that every written policy had expense involved from the actuaries down to the selling insurance agents. These expenses are reflected in the premium price. Obviously, consumers are not likely to pay the cost of a premium that is potentially higher than the actual loss would be. Even so, there are some types of coverage that is part of larger policies that do cover small items. Small losses that could be absorbed are seldom a worthwhile buy. Still, we see consumers buy such things as dread disease policies or hospital indemnity policies because the premium is low.

5. Affordable Premium Costs

The fifth point, affordable premium costs, is necessary. If not enough consumers purchase the insurance; the cost will not be low enough. If the cost is not low enough, there will not be enough quantities of insured.

6. The Chance of Loss Must Be Calculable

The sixth point, the chance of loss must be calculable, means the probabilities of loss can be determined by logic or by a tabulation of experience. Most types of insurance are determined empirically, which means by a tabulation of experience, which can be projected into the future. If no statistics on the chance of loss are available, the ability to accurately predict loss is low even if large numbers are available.



7. The Peril Must Be Unlikely to Produce Loss to Many People Simultaneously

The final point, the peril must be unlikely to produce loss to many people simultaneously, is not hard to understand. No insurer can afford to insure a loss that happens massively at the same time, such as loss due to floods or volcanoes. Although everyone will die at some point in time, insurers can still underwrite life insurance because it would be unlikely that all their policyholders would die simultaneously. War and acts of war, which might cause large quantities of death at once, are not covered.

WOMEN – INVESTING & RISK

Men tend to make riskier decisions than women. This phenomenon has been observed and documented in different contexts, including driving, health, and personal finance.

Studies have found that women in general are far more concerned with the fear of losing money (risk) than the chance of gaining it (return). Women tend to blame themselves if an investment loses money, whereas men will blame weak markets, bad advice, or bad luck. Because of this fear of losing money, too many women put their savings into more conservative, easy-to-understand investments—like savings accounts or GIC type investments.

In a recent survey from 2017, among Canadian women who hold investments, almost all (92 per cent) say they are either the primary or joint financial decision-makers in their households, yet only half feel confident or knowledgeable about their investing abilities.

Key Survey Findings

• 92 per cent of Canadian women with investment portfolios are the primary or equal decision-maker responsible for their household's investment decisions, including:

▪ 46 per cent who say they're the main decision-maker; and, ▪ 46 per cent who share the responsibility equally with a spouse,

parent or adult-child • 7 per cent defer responsibility to someone else, such as a spouse,

partner, parent or adult-child • Only half feel confident (54 per cent) or knowledgeable (49 per cent) about

investing • 29 is the average age when women start to invest • 73 per cent do not talk about investing regularly with their friends and

family



Investment Habits of Men Vs. Women

Here's an interesting point of debate: men and women differ in their approach to the investment game and the difference is quite marked during the initial process. Research has shown that men tend not to want too much detail while women want more information. Women tend to really want to understand what's being suggested, and why.

When it comes to investing, men and women might not see eye to eye. A recent poll showed that while both sexes take an active role in managing their investments, the way they do it—and the reasons they do it that way—differ. Men - Working Toward a Monetary Goal When it comes to investing, men tend to think in terms of pure numbers Men are driven to invest in order to measure their financial progress—i.e. how much money they have now versus what they may need in the future.

Men continue to profess confidence in their investments: 61 per cent of men surveyed agreed that they were good investors, and 36 per cent agreed that they are likely to study up on opportunities before making investments.

These statistics suggest that men are willing to be aggressive and take risks with their portfolios in order to meet their investment goals. Women - Working Toward Life Events In the poll, women reported that their investments are rooted in successfully saving for major life events—a child’s college education or their future retirement. They also cited wanting to have “peace of mind” about their finances, suggesting that they worry more than their male counterparts when it comes to finances.

In addition, women reported feeling less knowledgeable and confident about their investments: only 47 per cent agreed they were good investors (again, compared with 61 per cent of males), while only an astonishingly low 27 per cent of women felt knowledgeable about investment-related topics.

Meeting in the Middle While men and women may cite different motivators when it comes to managing their investments, both sexes agreed that having control over their future finances was their goal.



So, are the two philosophies really that divergent, or just articulated by each sex differently? After all, a child’s education (life event) will cost x (monetary goal) amount of dollars, just as x amount of dollars will ensure that a couple enjoys financial security after retirement.

The biggest difference, it seems, is that men tend to be more aggressive in their investments in hopes of meeting their financial goals. These risks, of course, can pay off. Women are generally less confident, and therefore, more conservative. But those traits may also lead them to ask more questions and consider their decisions more carefully, in turn leading to smarter investments.

Optimistically speaking, both genders can learn from and help one another to boost their portfolios. Of course, the best way to start building a more secure financial future is to get rid of debt.

A life insurance study indicated that only 1 in 9 widows will re-marry. This is important to know because some men think they don't need much life insurance because they feel that if they die their wife will re-marry.

However, a single mom who is trying to hold down a full-time job to make ends meet, or an older spouse who has been a housewife for many years, may not move in the right circles to find a new husband.

On the other hand, given the above study results on investment and budget skills, a widow who is left a life insurance inheritance may be able to successfully manage her financial affairs if she has enough money to work with and may not look to remarry. If the above study results can be applied to the general population it would seem that family units would do well to involve the female spouse both in investment and succession planning.

Longer Life Expectancy Equals Larger Earnings

The way your money may grow through compounding is the greatest single benefit a long-term investment plan can offer you. When you invest, you not only have the potential to earn money on what you've contributed, you also have the potential to earn money on your earnings. This is especially important for women since they tend to live longer and will need greater assets to rely upon in retirement. Compounding is one-way women can put their longer life expectancy to work for them.



Spread the Wealth – Don’t Put All the Women’s Money in One Basket!

When it comes to investing, the adage holds true—don't put all your eggs in one basket. When your investments are diversified or spread across different asset classes or types of securities, they work together to help reduce risk. Mutual funds, which invest in a broad range of different securities, are designed to be well-diversified investments.

Most investment experts recommend that individual investors combine growth-oriented investments like stocks or stock funds with more stable, fixed-income investments like bond and money market funds to help reduce risk and increase growth potential.

Just what balance works for you depends on your age, risk tolerance, and financial goals.

Financial Advisors can help you determine the right mix for your situation. Please remember that diversification cannot eliminate the risk of fluctuating prices and uncertain returns.

Stocks Versus Other Investments

While it's never a good idea to put all your assets in the stock market, many women tend to invest too little in stocks. You may end up with an investment plan that doesn't offer the growth potential to meet your needs.

Keep in mind that you assume greater risks when you invest in stocks, and that past performance is no guarantee of future results. Also, there is no guarantee that your investment will increase in value. However, the benefits of investing in stocks may outweigh the risks, especially since time is on your side.

Here Are Six Steps to Closing the Confidence Gap

1. Women should educate themselves 2. Women should keep cool when investing 3. They should set clear financial goals 4. They should create an investment plan 5. They should diversify their portfolio 6. They should talk to YOU…the financial expert or advisor

TEN SELF-DEFENSE TIPS AGAINST INVESTMENT FRAUD

1. Don't be a "courtesy victim." Most individuals are always taught to be courteous to phone callers, as well as to people who visit them at home. Con artists will not hesitate to exploit the "good manners" of a potential victim.



A stranger who calls and asks for your money should be regarded with the utmost caution. You are under no obligation to stay on the telephone with a stranger who wants your money. In these circumstances, it is not impolite to state that you are not interested and simply hang up the phone.

2. Check out strangers as well as their touted "deals." Say "no" to any investment advisor or salesperson who presses you to make an immediate decision, preventing you from checking out the person as well as the investment. Before you part with your hard-earned savings, get written information about the investment opportunity, review it carefully and make sure that you understand it before making any decisions.

A favourite tactic of telemarketing con artists is to develop a false bond of friendship with older people. If you are dealing personally with a stockbroker or financial planner, do not be swayed by offers of unrelated advice and assistance that are merely efforts to develop a sense of friendship and even dependency.

3. Always stay in charge of your money. A stockbroker, financial planner or telemarketing con artist who wants your money will be more than happy to assure you that he or she can handle everything, thereby relieving you of the need to watch over and protect your nest egg. Beware of any financial professional who suggests putting your money into something you don't understand or who urges you to leave everything in his or her hands.

Constant vigilance is a necessary part of being an investor. If you understand little about the world of investments, take the time to educate yourself or involve a family member or a professional, such as your banker, before trusting a stranger who wants you to turn over your money and then sit back and wait for results.

4. Never judge a person's integrity by how they "sound." Many older people who get wiped out by con artists later explain that the swindler "sounded like such a nice young man or woman." Successful con artists sound extremely professional and can make even the flimsiest investment deal sound as safe and sound as putting money in the bank. Some swindlers combine professional-sounding sales pitches with extremely polite manners, knowing that many older people are likely to equate good manners with personal integrity. Remember that the sound of a voice (particularly on the phone) has no bearing on the soundness of an investment opportunity.

5. Watch out for salespeople who prey on your fears. Con artists know that many retirees worry that they will either outlive their savings or see all their financial resources vanish overnight as the result of a catastrophic event.



As a result, it is common for swindlers and abusive salespeople to pitch their schemes as a way for older people to build up their life savings to the point where such fears are no longer necessary.

Remember that fear and greed can cloud your judgment and leave you in a much worse financial position. An investment that is right for you will

make sense because you understand it and feel comfortable with the degree of risk involved.

6. Exercise caution if you are an older woman with no experience handling money. Ask a con artist to describe his ideal victim and you are likely to hear the following two words: "elderly widow."

Sadly, many women who are now in their retirement years often received little or no education in their youth about how to handle money. Women of this generation often relied on their husbands to handle most or all major money decisions. As a result, older women, and particularly those who have received windfall insurance payments in the wake of the death of a spouse, are prime targets for con artists.

Elderly women who are on their own and have little know-how about handling money should seek the advice of family members or a disinterested professional before deciding what to do with their savings.

7. Monitor your investments and ask tough questions. Too many older people not only trust unscrupulous investment professionals and outright con artists to make financial decisions for them but compound their error by failing to keep an eye on the progress of the investment. Insist on regular written and oral reports. Look for signs of excessive or unauthorized trading of your funds. Do not be swayed by assurances that such practices are routine or in your best interests. Do not permit a false sense of friendship or trust to keep you from demanding a return of your savings. When you suspect that something is amiss and get unsatisfactory explanations, call your provincial securities commission and make a complaint.

8. Look for trouble when trying to retrieve your principal or cash out your profits. Many older people have little ongoing need for income from investments, while others need returns that are paid out regularly in order to supplement limited incomes. If a stockbroker, financial planner or other individual with whom you have invested stalls you when you want to pull out your principal or even just your profits, you may have uncovered someone who wants to cheat you. Since unscrupulous investment promoters pocket the funds of their victims, they often go to great lengths to explain why an investor's savings are not readily accessible.



In many cases, they will pressure the investor to "roll over" non-existent "profits" into new and even more alluring investments, thus further delaying the point at which the fraud will be uncovered. If you are not investing in a vehicle with a fixed term, such as a bond, you should be able to receive your funds or profits within a reasonable amount of time.

9. Don't let embarrassment or fear keep you from reporting investment fraud or abuse. Older people who fail to report that they have been victimized in financial schemes often hesitate out of embarrassment or the fear that they will be judged incapable of handling their own affairs. Some investors have indicated that they fear that their victimization will be viewed as grounds for forced institutionalization in a nursing home or other facility. Recognize that con artists know about such sensitivities and, in fact, count on these fears preventing or delaying the point at which authorities are notified of a scam. While it is true that most money lost to investment fraud is rarely recovered beyond pennies on the dollar, there are also many cases in which older people who recognize early on that they have been misled about an investment are then able to recover some or all their funds by being a "squeaky wheel." A good resource for older people who fear that they have been victimized by a con artist is the securities agency in the province in which they live.

10. Beware of "reload" scams. Younger people who are ripped off by swindlers are fortunate to the extent that they can pick themselves up and restore some or all their losses through new earnings. However, most older people are dealing with a finite amount of money that is unlikely to be replenished in the event of fraud or abuse. The result is a panic that is well known to con artists, who have developed schemes to take a "second bite" out of older individuals who have already been victimized. Faced with a loss of funds, some elderly citizens will go along with another scheme (allowing themselves to be reloaded, in effect) in which the con artist promises to make good on the original funds that were lost ... and possibly even generate new returns beyond those originally promised. Though the desire here to make up lost financial ground is understandable, all too often the result is that the unwary senior citizens lose whatever savings they have left in the wake of the initial scam.

KNOW YOUR CLIENT (KYC) RULE

It is imperative that ALL Advisors ENSURE that they are doing the right thing for their clients and prospects.

September 11, 2001 made a significant impact on future Know Your Client documents. This was necessary to ensure that any funds given to Insurance and Investment companies were non-terrorist related.



In Canada, the securities regulators have for some time had a "Know Your Client" rule, which basically states that financial planners & brokers must have collected certain basic information about a client's financial picture to properly advise them on their investments.

As such, planners are required to have a signed Know Your Client form (generally abbreviated to KYC form, and at least one wise guy or lady in every office will start calling it a KFC form) from every client.

Some discount brokerages, where ostensibly the only trades are from clients who do not want advice, are exempt or partially exempt from this rule.

After your client has chosen a firm and an individual within the firm, as an Advisor, you will complete several forms to open their account. Some of these forms (e.g., the cash or margin account agreements) describe the nature of their account(s) and the legal rights and remedies available to both the client and the firm in case of a dispute.

These forms are often dry reading, full of legal language. Even so, the client should read and understand the forms before they sign. If they don't understand part of a form, explain it to them line-by-line if necessary.

The cardinal rule for every dealer and adviser is that they must know their client. In other words, he or she must learn the essential facts relative to every client and must determine the general investment needs and objectives of the client.

To help him or her do this, most firms prepare a detailed New Client Account Form (also called a Know Your Client form) that contains key personal and financial information about the client. While the detailed questions may seem somewhat invasive, the information that the client provides in this form is necessary if the dealer or adviser is to provide effective service and prudent advice.

The form will generally include the client’s name, address, employment information, credit references, income, net worth, investment experience, risk preference and investment objectives. Most forms also ask whether anyone else has any interest in or authority over their account, and whether they are an insider or control person of any public companies. They may also include information relating to the transfer and registration of securities held in their account.

Many firms now use forms that require the signature of the client. Before they sign the form, they will make sure that everything in it is correct. Errors in the form may lead to inappropriate advice and may erode the legal protections that they are entitled to if something goes wrong.



Give the client a copy of the form and keep a copy with their account records. Make sure that you contact the client (preferably in writing) to have the form updated whenever the information in it changes.

This is particularly important with key information such as their address, personal financial circumstances and investment objectives.

In some jurisdictions, many dealers that simply provide trading services at an investor's direction and do not offer advice have received an exemption from the Know Your Client Rule.

In most cases, the client will also be asked to complete a shareholder communication form in which they will indicate the amount of information, such as annual reports, financial statements, proxy circulars and notices of the shareholder meetings that they wish to receive from the companies in which they invest. The form will also ask whether they consent to the disclosure of the client’s name and securities holdings to those companies. Not all the questions are mandatory, but most are.

Here Is What the Investment Dealer Association of Canada Says About the Know Your Client Requirements for Non-Individual Accounts

Overview

Current rules and industry practice require those authorized to trade on behalf of corporations, trusts and similar entities to be identified and documented. This proposal addresses the issue of the need to know the beneficial owners behind a corporate account.

The highlights are:

• Beneficial ownership information requirements refer to individuals, whether their ownership is direct or indirect as in ownership through other corporations or trusts;

• Knowledge of beneficial ownership is not required for certain types of corporations and trusts;

• For new accounts of private corporations and similar entities, the identity of the beneficial owners must be obtained and verified;

• For new accounts of trusts the identities of the settlors and beneficiaries, where known, must be obtained and verified;

• Where the identities of beneficial owners, settlors or beneficiaries, as appropriate, are not known for accounts open at the time the changes are implemented, Members will have one year after implementation to obtain the information.



An exemption for the accounts of financial institutions regulated in their home jurisdictions and their affiliates is provided. However, the Association is empowered to remove the exemption for financial institutions in jurisdictions found by the Government of Canada or international organizations of which Canada is a member to have deficient regulatory regimes.

An exemption is also provided for publicly traded corporations, trusts and similar entities and their affiliates. It should be noted that this proposal represents a significant change from the current practice and requirements in the industry today.

As stated previously, current rules and industry practice require that those authorized to trade on behalf of corporations be identified and documented.

Current rules include:

• The "Know Your Client" rule as detailed in IDA Regulation 1300.1;

• The requirements under the Proceeds of Crime (Money Laundering) and Terrorist Financing Act 2000 ("the Proceeds of Crime Act" and the regulations thereto; and

• In the case of accounts of United States citizens and accounts with holdings in United States issued securities, Sections 1441 and 1442 of the United States Internal Revenue Code.

Although the Securities and Investment communities have long been using the Know Your Client form, the Insurance and other financial companies such as Managing General Agencies have adopted their own version of a Know Your Client form that is now in use.

Some Other Information About the Know Your Client Form That You May Want to Know About:

The Know Your Client form stipulates that only the following are needed before advice can be given, however, individuals may also not realize that you do not actually need to sign this form to validate its use within the organization. In fact, they do not even need to receive a copy of it.

The KYC form should contain the following information:

1. Investment knowledge; extensive, moderate, none. 2. Risk tolerance; low, medium, high 3. Time Horizon; 1 to 3, 4 to 5, 6 to 9, 10 plus 4. Investment Objective; income, growth (short/long term), balanced. 5. Individual income and household net worth



The KYC was only ever intended to assess the suitability of individual transactions and not the suitability of a portfolio or the suitability of a transaction within a portfolio. Indeed, this presumption is supported by securities case law.

1. Investment Knowledge

Merely asking a client’s investment knowledge is insufficient to communicate the necessary information needed to establish suitability within the wider context.

Merely asking the extent of an individual’s investment knowledge is enough to assess whether a client who is initiating a transaction request, and who may not rely on their advisor to assess suitability, has the expertise needed to initiate the transaction; although, even here, investment advisors can affect client-initiated transactions that are not suitable within the parameters of the KYC.

2. Risk Tolerance

A general statement of risk tolerance is insufficient to assess suitability in the wider context. Indeed, many investors assess their risk aversion based on their perceived need for security; how a portfolio is structured, planned and managed to meet financial needs over time and how that portfolio is designed to manage significant risks is key to the individual’s ability to assess their attitudes to risk.

For suitability to be confirmed, investors need education over the basics of investment and of the advisor’s investment discipline and risk management process. If the risk assessment process does not educate the client over the risks likely to impact the ability of their portfolio to meet their financial needs over time, then logically, it is unlikely that the recommendations can be proven to be suitable.

In this case, there are two conclusions

1. The first is that the KYC can only be used to assess the efficacy of a transaction on a transaction by transaction basis by someone who understands risk and who is initiating the transaction request.

2. Secondly, where a KYC is used for clients who are relying on their advisors for their expertise to provide a portfolio solution, the advisor is taking a fiduciary responsibility about the provision of a wealth management solution.

Moreover, if the risk assessment process does not assess all the key risks likely to impact on the ability of the portfolio to meet financial needs as well as the performance risks of an investment style, then the advisor will have failed to properly satisfy their fiduciary duty.



Most risk assessments fail to educate the client over risk, fail to properly assess risk and fail to provide the client with a meaningful illustration of the impact of their risk preferences.

3. Time Horizons

Time horizons are rarely singular and are more likely to be multiple and relative. All transactions impact on the risk/return relationship of all assets and on the relationship between all assets and all financial needs. For this reason, service processes that rely on singular time frames cannot manage the suitability of the transaction.

Only the individual that can break down their needs and objectives into multiple time frames and multiple individual allocations per time frame (meaning they will have needed to carry out a complex asset and liability analysis), can initiate transactions on a transaction by transaction basis.

Because of this, the “know your client” form has little or no relationship with the fundamental precepts of suitability and is an inappropriate foundation for delivering wealth management solutions that need to address the total portfolio management problem.

4. Investment Objective

The investment objective approach noted in the “KYC” is at best an antiquated approach to selecting broad portfolio options. It provides no information about the size and timing of financial needs over time and hence no information as to the actual structure of the portfolio needed to meet actual needs.

The objective of the client can only be determined by the relationship between financial needs over time and the size and disposition of assets over time. Broad objectives, while sometimes useful for delivering broad model portfolio options, are totally unsuitable for defining the suitability of individual security transactions. Likewise, broad, fixed, model portfolio options are inefficient in providing personalized solutions.

Unless an advisor has knowledge of the disposition of all assets and all financial needs it is impossible to work out from a broad objective just what asset class and specific security the individual is deficient in. Additionally, and, logically, if the advisor does have an idea of disposition of assets and needs over time, without written communication of the rationale for the allocation and the asset class, security selection is a discretionary decision; if one assumes that suitability is the framework and the transaction merely an allocation within it.



As with many of the other components of the KYC, the only way the “investment objective” can work on an individual security transaction is for the client to take responsibility for the rationale and reason. Perversely, this implies that the investor has significant ability to structure, plan and manage allocation, which is far from the truth.

5. Individual income/household net worth

Both important pieces of information, yet the KYC totally ignores the importance of finding out the size and disposition of financial assets (key to working out where the gaps are in the portfolio structure and what to buy and/or sell) and the actual financial outgoings key to determining the relationship between assets and financial needs.

Why Do Minimum Standards Exist in the KYC Form & What Are Their Objectives?

Within a transaction led industry, minimum standards were designed to provide structure to the process in which transactions were recommended. They were not designed to provide minimum standards for the delivery of transactions within a portfolio construction capable of managing the ability of assets to meet financial needs over time. As such, they do not cover suitability for individuals relying in their advisor for their expertise in crafting wealth management solutions.

Is the objective of a transaction industry to provide total wealth management solutions?

No, it is not! Is it possible to raise standards within a transaction driven industry so that transactions are suitable to financial needs, reflect total assets and the relationship between assets and financial needs and risk preferences? No, it is not!

The only way you can do it is to change the objective of a transaction driven industry. This is difficult if regulation is still focused on managing a transaction led process and, the arbitration and legal system one which assesses the parameters of a transaction driven framework in determining fault.

Now in time minimum standards are important because they keep the status quo in check. It is debatable whether the industry could move to a service led business process that would be demanded by raising the minimum standards governing suitability of advice.

While it is in the industry’s interest to keep standards at a minimum, if legal precedent were to start looking at wider standards governing suitability, current minimum standards could become a liability.



Suitability of a Know Your Client form

There are five dimensions or component rules that comprise suitability. These are as follows:

1. An investment that is recommended must relate to:

a) the actual size and timing of financial needs over time and

b) the relationship between financial needs and total assets over time (both current and future disposition of capital).

This is complex, yet extremely simple to solve providing an organization has the necessary decision rules that relate portfolio construction to financial needs over time.

2. After relating the allocation to a given investment or set of investments based on financial demands on the portfolio over time, the investment must then be able to relate to attitudes to risk and investment preferences. It is these risk and performance preferences that either increase the income and capital security of the portfolio or increase/reduce the risk/return relationship of the portfolio.

We all live in the same investment universe but our risk preferences (in addition to our financial needs) determine our final position within it. These relationships are again complex, but simple to solve providing you understand the decision rules that relate risk preferences and financial needs to all points of the universe.

3. Thirdly, the recommendation must relate to all existing investments and the relationship that exists between these investments and financial needs at a point in time and over time. A recommendation may be a suitable investment if we just look at a simple profile, but if you already have enough of it, it may not be suitable. Being able to identify the asset allocation gaps in the portfolio and being able to relate the security to an asset allocation (and hence a valuation framework) is not an easy job.

Again, an horrendously complex procedure if done manually, but extremely simple if you can model the relationship between all components of 1 and 2 above.

4. Fourthly, the recommendation made must make sense given the price of the investment at the time and the risks the investment is exposed to over time. Initial investment risk is a key risk aversion for many investors and many investors rely on their advisor’s assessment of initial investment risks.



Buying an overpriced security (or portfolio of securities) poses significant risks to future financial security. Indeed, while it may be virtually impossible to predict market timing it is possible to ascertain valuation risks to future return.

If you are managing suitability you should not just be managing volatility but liability risks (risks to the ability of assets to meet planned financial needs over time).

5. Suitability can only be fully assessed with client interaction in the decision-making process. This also means that education and communication regarding the basics of investment, the risks of investment, the manager’s investment style and how portfolios are constructed, planned and managed to meet financial needs over time are key to agreeing suitability of transactions, products and recommendations.

Education and communication are also keys to managing fiduciary risk which is a risk organization take if they do not address the importance of education and communication. But as with all the above components, the ability to manage these components effectively requires a centralized wealth and asset management process.

Without communication of where the advisor stands on the first four rules of suitability, it is unlikely that a client can make an informed decision about transactions within an advisory relationship and an informed ex post assessment within a discretionary relationship or about the suitability of portfolio management structures within both advisory and discretionary relationships.

Rule 1 – Relationship with Financial Needs Over Time

If your advisor does not know the disposition of the client’s assets and the disposition of all known or likely needs, or the specific assets and specific needs related to the mandate at hand, he or she cannot fulfill rule 1.

Irrespective of the process or discipline used by an advisor, transactions need to pass a suitability test defining the process in which the structure, planning and management of assets meet financial needs as and when they arise while managing the risks and the costs of such a process.

Since every investor has the right to know the limitations of the service they are receiving in this respect, a fiduciary duty should involve communication of the portfolio construction, planning and management process and its limitations about suitability.



An organization where the logically inherent limitations of a service are not communicated to a client, is taking a fiduciary risk, especially when promises of personalization, customization or risk management are made.

Since the structure of the portfolio and how it manages the risks to the ability to meet financial needs over time is key to risk aversion, the client also needs communication of this discipline and to be able to assess their aversion to this risk.

Rule 2 – Relationship with Attitudes to Risk and Performance Preferences

If the amount that is allocated to each primary asset class and security is based on financial needs, then each recommended portfolio should be unique.

However, what may be the most efficient asset allocation of transactions for the advising company’s assessment of the investment universe, based on their disciplines, may not be one which the investor feels comfortable with.

Advisors that do not relate the structure, planning and management of assets to meet financial needs to all key risk factors (liability, performance/style and volatility/aggressive/conservative) will not be able to address the suitability of the portfolio to the client’s main risk preferences. As such the management of expectations regarding these key risks cannot be effectively conducted.

This leaves the advising company exposed to suitability risks, irrespective of whether the relationship is advisory or discretionary. It also implies that the company has taken responsibility for the management of this risk themselves, which implies a fiduciary duty. Indeed, this applies to any component of suitability which is not explicitly explained to the client or managed by the advisor.

It is therefore important for organizations where rule 1 is not assessed and where attitudes to the risks associated with rule 1 are not addressed, that they specifically explain that these risks are not addressed within the construction, planning and management of assets.

This fiduciary risk is particularly important where investors are depleting capital over time and where inappropriate portfolio structures and costs will impact on the ability of the proposed transaction solution to meet needs and protect against risks.

Sadly, the industry does not consider itself responsible for managing these risks. Unless a firm specifically states that it will not manage these risks and explains the consequences to investors of not managing these risks, it should be responsible.



Otherwise the advisor will be asking individuals to manage risks they do not understand and are incapable of assessing or compensating for while recommending transactions that are unsuitable, without structure and proper risk management.

It is paradoxical that in the absence of statements to the contrary, minimum industry standards that do not satisfy rules 1 and 2 are effectively forcing a higher level of fiduciary responsibility onto the companies themselves.

After all fiduciary duty, rightly or wrongly, implies the existence of discretion over issues which the investor is ignorant and incapable of managing on their own, which the individual has implicitly devolved to the advisor and, for which the advisor has implicitly accepted responsibility. This responsibility is not assessed within the legal system or the complaints process because of ignorance over suitability and its structure.

Indeed, within an advisory relationship the only decision which an individual has retained control over is the acceptance or not of the transaction initiated and understood in the first instance by the advisor and, to which less information than is needed to develop the recommendation is provided to the investor. Again, a significant level of discretion is retained over the decision by the advisor in advisory relationships.

Rule 3 – Must Relate to All Existing Investments

All recommendations should take place within an asset allocation framework determined by financial needs, risk preferences, the manager’s investment style and valuation/risk relationships.

The individual security selection should relate to the recommended asset allocation and security selection for a given client return/yield/risk/liability profile.

A broker cannot just phone you up and say, “I have this great investment” nor can a discretionary manager include the flavour of the month investment without being able to relate it back to the portfolio construction, planning and management framework.

The justification for a security recommendation cannot be your profile as suggested by the “know your client form”. If this were the case any investment on its own would be suitable.

The suitability of an investment can only be viewed by its position within the portfolio, its effect on asset allocation, valuation and on risk and return over time relative to financial needs. As discussed later the “Know Your Client” form does not actually provide a structure for the management of assets and needs.



It is a transaction profile wholly inappropriate for the proper management of assets and financial needs.

The only time a broker should be recommending a single transaction is where the client is in a transaction relationship. Such a relationship should only exist where the client has knowingly taken full responsibility for the management of their assets. Indeed, a great many advisory relationships are relationships in which the individuals wholly rely on the advisor’s expertise.

Rule 4 – Must Relate to Current Risk/Return Relationships in The Market Place

If suitability relates to the management of risks likely to affect the ability of assets to meet financial needs over time, then the initial investment decision is important.

The current valuation of an asset is material to the suitability of the asset and the management of expectations.

It is not enough to say that an asset is high risk/high return, since valuation is the biggest factor in risk at a point in time. Most risk statements do not cover the current valuation risk material to understanding the investment decision.

If the current valuation and hence the valuation risks of an asset are not being taken into consideration, then advisors are in breach of their fiduciary duty irrespective of whether they are operating under a discretionary or an advisory mandate.

Indeed, those operating under an advisory mandate have discretion over the parameters of the initial investment decision if they fail to disclose current valuation risks and only disclose historical risk/return relationships.

Whether you are in an advisory or discretionary relationship the initial investment decision is material and both discretionary managers should go through the same risk assessment process about this risk and need to disclose the process in which these risks are assessed and managed.

Rules 5 – Suitability and education

If a client has not been educated over the portfolio construction, planning and management process used by the advisor and cannot relate this to the management of their financial objectives, it is unlikely that they can realistically have accepted the recommendation.



If a client has not been educated over the basics of investment or the risks of investment, then the advisor is taking discretion over the suitability of an investment and the resulting transaction recommendation irrespective of the client relationship, whether it be advisory or discretionary.

Education and communication is important in terms of determining where in the universe the client is in relationship to the investment advisor. Communication (reporting) is important in confirming the rationale for all material decisions and for communicating the rationale for the management of the portfolio and the attendant risks of the strategy.

Quite how an investor is bound to accept the risks of an investment transaction without clear and formal communication is of enormous concern.

Investments should not be considered only as transactions unless the client has specifically requested and self-initiated a transaction request and has confirmed responsibility for the suitability components.

Responsibility and Suitability in The Transaction Environment

The only time a transaction can be clearly assessed as a stand alone transaction should be when an experienced and sophisticated investor uses his or her investment advisor to solicit a security or a trade idea.

In this sense, the individual investor is assumed to have taken full responsibility for the consequences of the transaction and for all issues of suitability.

Individual investors who do not have the expertise to be initiating transaction decisions, but do, are also taking responsibility for issues of suitability and relieving their investment advisors of their fiduciary duty. All the investment advisor has responsibility for in this instance is that the trade recommended matches the suitability profile of the individual, although even here advisors can execute unsuitable trades if the client specifically requests this.

Investors relying on their investment advisor for advice and are inexperienced in investment must note that it is important that they do not start initiating transaction decisions.

Although, making sure you have a proper mandate and agreement as to how the account will be managed is an important prerequisite.

In terms of suitability, once an individual investor starts to initiate their own transaction decisions they may negatively impact the portfolio construction, planning and management framework instituted by their advisor.



Individual investors without the necessary expertise are going to be making trades that do not meet the rules of suitability and that will violate the structure of the portfolio. An advisor should not be held responsible for this, although they should be responsible for informing the individual of the risks they are taking.

It is important that the mandate for the advice and the framework in which the relationship will be carried out is agreed in advance so that issues of responsibility, suitability, duty of care and fiduciary duty are covered.

Two Types of Suitability Transactions

What is also important to understand is that there are two types of transaction within the wider environs of suitability. There is the transaction between securities designed to reduce risk and or enhance return and there is the transaction initiated by the relationship between financial needs and assets.

An investor can initiate the second type of transaction without violating their mandate or the advisor’s fiduciary duty towards them if it is the manager that makes the transaction decision. For example, I need to spend C$30,000 in two years’ time, please provide me with the capital at the time.

It is important to realize that whatever the relationships mandate, advisory or discretionary, where the client is reliant on the advice of the advisor that the advisor will be initiating the recommendation and the reasons for the recommendation. Because of this it is therefore important that suitability lies behind all decisions irrespective of the mandate (advisory or discretionary).

The Prerequisites of Suitability

An organization must have the necessary expertise, investment discipline, resources, business and services processes and systems needed to deliver personalized wealth management to be able to deliver suitability.

If you are recommending an asset class but do not know how to value it, manage it or to incorporate it within a portfolio suitable to client financial needs and risk preferences, then are you being negligent and in breach of an implicit fiduciary duty. Most clients must trust their advisors and because of this most clients are vulnerable if their advisors do not have the expertise, systems, resources or business and service processes to deliver.

Suitability Conclusions

Suitability is a framework, not a transaction. It is unlikely that a client could ever fully ratify suitability without knowledge of the rationale for the transaction and structure in which the risks and returns of the investment are managed.



In this sense even, an advisory relationship is operating with discretion over the framework governing suitability.

It is also unlikely that a client who has not been properly educated about the construction, planning and management process will be able to understand whether something is suitable or not and therefore is unlikely to ever fully be able to mitigate unsuitable or inappropriate advice successfully.

Since it is the responsibility of all advisors, whether they be discretionary or advisory, to ensure that all transactions and structures are suitable, even a discretionary relationship should have structures developed by interaction with the client.

In fact, we need to assess the true nature of suitability to fully understand the responsibility that all advisors are taking and, the duty of care they are responsible for providing. Most clients are vulnerable in the face of the complex world of portfolio personalization.

Just what is the difference in duty owed by an advisor who works on a discretionary basis to one who works on an advisory basis? For investors who do not possess the expertise and who rely on their advisors, next to no difference whatsoever

Suitability is a cornerstone of all portfolio management. It is where the management of assets meets the management of financial needs and where the approach and discipline of the manager is tailored to the risk and performance preferences of the individual. All factors noted above also apply to the management of discretionary portfolios.

PRIORITY OF POLICYOWNERS INTERESTS SHOULD ALWAYS BE FIRST & FOREMOST

An Advisor / Broker must always place the client’s needs before their own in any dealings with them. This one is self-explanatory. Just remember the “Do unto others” rule. If you wouldn’t buy the plan from yourself, then ask yourself why. Look after your clients and prospects, and they will look after you.

CANADIAN SECURITIES ADMINISTRATORS

Securities regulators from each of the 10 provinces and 3 territories in Canada have teamed up to form the Canadian Securities Administrators (CSA). The CSA protects Canadian investors from unfair, improper, or fraudulent practices and fosters fair and efficient capital markets.



The 10 provinces and 3 territories in Canada are responsible for securities regulations. Securities regulators from each province and territory have teamed up to form the Canadian Securities Administrators, or CSA for short. The CSA is primarily responsible for developing a harmonized approach to securities regulation across the country.

The CSA brings provincial and territorial securities regulators together to share ideas and work at designing policies and regulations that are consistent across the country and ensure the smooth operation of Canada's securities industry. By collaborating on rules, regulations and other programs, the CSA helps avoid duplication of work and streamlines the regulatory process for companies seeking to raise investment capital and others working in the investment industry.

In recent years, the CSA has developed the “passport system" through which a market participant has access to markets in all passport jurisdictions by dealing only with its principal regulator and complying with one set of harmonized laws. It is a major step forward in improving Canada’s securities regulatory system by providing market participants with streamlined access to Canada’s capital markets.

The CSA's impact on most Canadians comes through its efforts to help educate Canadians about the securities industry, the stock markets and how to protect investors from investment scams.

The CSA provides a wide variety of educational materials on securities and investing. It has produced brochures and booklets explaining various topics such as how to choose a financial adviser, mutual funds, and investing via the internet. All CSA materials are available in the Investors’ Tools section of the CSA Website and through your local securities regulator.

Access Rules and Policies

Because of the harmonization efforts of the CSA, securities markets are governed by several largely harmonized national or multi-lateral instruments which apply to:

• Efficiency of the securities market and trading rules, • Registration and related matters, • The distribution of securities, • Continuous disclosure, • Take-over bids and special transactions, • Securities transactions outside the jurisdiction, • Mutual funds, • Derivatives. • Upholding the law, enforcing the rules & holding people accountable.



Investigation and enforcement are core CSA responsibilities. By identifying violations of securities laws or conduct in the capital markets that is contrary to the public interest, and by imposing appropriate sanctions, the CSA deters wrongdoing, protects investors, and fosters fair and efficient capital markets in which investors can have confidence. Enforcement personnel of CSA member authorities deal with potential securities law violations identified by internal CSA member compliance and surveillance departments or because of complaints from market participants and the public.

The CSA’s enforcement activities complement those of other agencies with whom we cooperate and share information on matters of mutual interest. This allows the CSA to focus activities and prioritize resources where most appropriate.

Securities tribunals Enforcement personnel of CSA members can bring matters before a specialized administrative tribunal which, in most jurisdictions, is the local securities commission. Such tribunals can, among other things:

• Impose sanctions; • Issue cease trade orders against offenders; • Make exemptions unavailable to offenders; • Ban offenders from acting as corporate directors or officers; • Require the filing of specified disclosure; • Impose monetary penalties and the payment of costs; and • Prohibit offenders from disposing of funds, securities or other assets.

In some cases, enforcement personnel negotiate settlement agreements under which the alleged offenders submit to agreed sanctions. In some jurisdictions, these settlement agreements are approved by enforcement personnel; in others, they are subject to approval by the local securities commission or administrative tribunal. CSA members act jointly in approving some settlements and taking enforcement action

INVESTMENT INDUSTRY REGULATORY ORGANIZATION OF CANADA (IIROC)

IIROC carries out its regulatory responsibilities under Recognition Orders from the provincial securities commissions that make up the Canadian Securities Administrators (CSA). IIROC is subject to oversight and regular operational reviews by CSA members.



Investment dealers are required to be members of the Investment Industry Regulatory Organization of Canada (IIROC). IIROC is responsible for regulating its members by:

• Setting regulatory standards, • Confirming advisors and sales representatives meet education and

qualification standards to be licenced, • Auditing members for compliance with those standards, • Investigating complaints, and • Taking enforcement action when necessary.

Unlike the securities commissions, the MFDA and IIROC are not government agencies. They operate under the authority and supervision of the securities commissions. However, they have the power to impose standards that are higher than the minimum standards set by securities laws.

MUTUAL FUND DEALERS ASSOCIATION (MFDA)

The Mutual Fund Dealers Association of Canada (MFDA) is the national self-regulatory organization (SRO) for the distribution side of the Canadian mutual fund industry. The MFDA is structured as a not-for-profit corporation and its Members are mutual fund dealers that are licensed with provincial securities commissions.

The MFDA is formally recognized as a self-regulatory organization by the provincial securities commissions in Alberta, British Columbia, Manitoba, New Brunswick, Nova Scotia, Ontario, Prince Edward Island and Saskatchewan. An application for recognition is pending before the Superintendent of Securities of Newfoundland and Labrador.

See SRO Application and Recognition Process to read more about this subject.

The MFDA has also entered into a Co-operative Agreement with the Autorité des marchés financiers and actively participates in the regulation of mutual fund dealers in Quebec.

As an SRO, the MFDA is responsible for regulating the operations, standards of practice and business conduct of its Members and their representatives with a view to enhancing investor protection and strengthening public confidence in the Canadian mutual fund industry.

The majority of the MFDA’s staff, centered in Toronto with offices in Calgary and Vancouver, are actively involved in compliance and enforcement activities.



As of July 31, 2018, the MFDA has 91 Members. See the Member Directory for an up-to-date list of MFDA Members. These Members represent approximately $556 billion of mutual fund assets under administration.

MFDA Members are registered in every province and territory of Canada and are the sponsors of approximately 80,440 mutual fund sales persons. For further statistical information, visit the Membership Statistics page.

The MFDA performs no industry representation or trade association activities for its Members.

The MFDA has a pretty stringent Code of Conduct in the form of Rules and By-laws that applies to all their individual and corporate members.

The following section of the MFDA Rules sums up the basics of their Policies and Regulations that all members adhere to.:

1.2 INDIVIDUAL QUALIFICATIONS

1.2.1 Compliance with MFDA Requirements

Each Member shall ensure that any Approved Person executes and delivers to the Member an agreement in a form as prescribed from time to time by the Corporation agreeing, among other things, to be subject to, comply with and be bound by the By-laws and Rules.

1.2.2 Registration

An Approved Person must have satisfied any applicable proficiency and other registration requirements set out in securities legislation and established by the securities regulatory authority having jurisdiction.

1.2.3 Education, Training and Experience

An Approved Person must not perform an activity that requires registration under securities legislation unless the Approved Person has the education, training and experience that a reasonable person would consider necessary to perform the activity competently, including understanding the structure, features and risks of each security that the Approved Person recommends.



1.2.4 Training and Supervision

Upon commencement of trading or dealing in securities for the purposes of any applicable legislation on behalf of a Member, all Approved Persons who are salespersons shall complete a training program within 90 days of such commencement and a concurrent six month supervision period in accordance with such terms and conditions as may be prescribed from time to time by the Corporation, unless he or she has completed a training program and supervision period in accordance with this Rule with another Member or was licensed or registered in the manner necessary, and is in good standing, under applicable securities legislation to trade in mutual fund securities prior to the date of this Rule becoming effective.

1.2.5 Misleading Business Titles Prohibited

No Approved Person shall hold him or herself out to the public in any manner including, without limitation, by the use of any business name or designation of qualifications or professional experience that deceives or misleads, or could reasonably be expected to deceive or mislead, a client or any other person as to the proficiency or qualifications of the Approved Person under the Rules or any applicable legislation.

CANADIAN BANKERS ASSOCIATION (CBA)

Voluntary Commitments and Codes of Conduct - CBA Code of Conduct for Authorized Insurance Activities Insurance Activities

The Purpose of this Code

Canada’s chartered banks are committed to meeting their customers’ insurance needs by providing them with access to authorized insurance products in a manner that serves customers’ interests. Banks will ensure that representatives offering these products are knowledgeable, provide clear product disclosure, respect customers’ privacy, and provide prompt investigation of any problem’s customers may experience.

This code sets out the minimum standards that apply to bank representatives who promote authorized insurance products in Canada. The banking industry, through the Canadian Bankers Association, will review this model code from time to time to make sure that it is relevant and up-to-date.



The Scope of this Code

This code applies to all authorized insurance products promoted in Canada and to the banks, their employees and/or any independent intermediaries acting as the banks’ agents (collectively referred to as "representatives" throughout the code) who promote authorized insurance products.

Authorized insurance products are those prescribed for the purposes of Section 416 of the Bank Act in the Insurance Business (Banks) Regulations.

These include the following defined types of insurance and any additional types that may be prescribed by future amendments to these regulations:

• Credit or charge card-related insurance, • Creditors’ disability insurance, • Creditors’ life insurance, • Creditors’ loss of employment insurance, • Creditors’ vehicle inventory insurance, • Export credit insurance, • Mortgage insurance, • Travel insurance, and • Personal accident insurance

Compliance with this Code

Each bank is responsible for ensuring that this code of conduct is implemented, understood and followed by its representatives. Each bank ensures compliance with this code of conduct and designates an officer to be responsible for compliance with this code.

Training

Bank representatives who promote authorized insurance products are properly trained, qualified and knowledgeable.

Banks are committed to providing continuing education to their representatives on authorized insurance products.

Banks will review educational programs on an on-going basis to ensure relevance to marketplace developments.



Disclosure

Banks are committed to providing clear and understandable disclosure in the documentation related to authorized insurance products. This helps consumers to make informed decisions about the insurance products promoted by banks.

Banks will provide each eligible customer who is accepted for insurance coverage with disclosure documentation that sets out:

• That the product being applied for is an insurance product; • Key terms and definitions related to the insurance; • All customer fees and charges associated with the insurance product and

how they would be payable; • That insurance coverage from a specific company is optional if a separate

charge is levied for the coverage (an example of insurance for which a separate charge is not applied would be coverage through a specific credit card);

• Name of the primary insurance company underwriting the insurance product ;

• How and when the customer will be notified of acceptance or rejection of the insurance coverage;

• When insurance coverage would come into effect and when it would terminate;

• The duration of any "free look" period during which, should the customer elect to cancel the insurance coverage, all premiums charged would be refunded;

• The customer’s responsibilities and the right to cancel insurance coverage at any time;

• Terms and conditions that might limit or exclude coverage; • Claims procedures; and • How to obtain additional information about the insurance coverage.

Promotion Practices

Banks will not impose undue pressure on or coerce a person to obtain a product or service from a person, including the bank and any of its affiliates, as a condition for obtaining another product or service from the bank. For further information, see the banks’ brochures on coercive tied selling.

Bank representatives promoting authorized insurance products will make all reasonable efforts to ensure that:

• The insurance policy or coverage being promoted is appropriate for the credit product or the needs as expressed by the person; and

• The person understands the coverage.



Privacy of Personal Information

To protect customers’ privacy, banks comply with the provisions of the Personal Information Protection and Electronic Documents Act.

In the case of creditor insurance, the insurer may require health information. This information is provided separately by the customer exclusively for the insurer. This information may be gathered by the bank on behalf of the insurer but will not be used by the bank or any of its subsidiaries or affiliates to help assess loan applications or market other products.

Continuity of Coverage

There may be situations where customer-initiated changes in the financing or other terms and conditions of a banking arrangement could result in the need to apply for new authorized insurance coverage.

Bank representatives will make customers aware that they:

• Are choosing to terminate their insurance coverage; • Are applying for new coverage and will be subject to the provisions of the

new coverage; and • Should review the decision carefully, particularly if there has been a

change in their health or other circumstances since they applied for the initial coverage.

Complaint Procedures

Banks have well-established policies and procedures to receive, investigate, and respond to customers’ complaints with respect to the promotion and administration of authorized insurance products. The bank informs customers of these procedures, which are easy to understand and use. These procedures set out a clear complaint resolution process and identify appropriate contact persons within the organization. Information concerning these complaint procedures is available from personnel at any branch, at the bank’s website and in printed brochures that explain the process in detail.

Banks make every effort to respond to complaints fairly and promptly.

If customers are not satisfied with the way their bank has responded to their complaint, they can contact the bank’s ombudsman. Contact information for the bank’s ombudsman is available in branches, on the bank’s website or on the Canadian Bankers Association website).



If customers have already pursued their complaint through the bank ombudsman and are still not satisfied, they can call the external complaints body to which their bank belongs.

WHAT SHOULD INVESTORS EXPECT FROM THEIR PORTFOLIOS?

A recent consensus (2016) was that balanced portfolio returns will range from 5% to 6% on an average annual basis. They also provided estimates of inflation between 1.8% and 3%, suggesting real returns (after inflation) of at least 2% to 3%.

Two years later these projections are consistent with assumptions prepared by the Financial Planning Standards Council for financial planners. Return assumptions for a balanced portfolio range from 4.55% for a conservative portfolio (70% bonds) to 6.05% for an aggressive portfolio (75% stocks).

Now, here's the clanger, these returns are before fees, expenses and taxes.

And they don't factor in investor behaviour. Factors that may further reduce returns include:

• Buying high, selling low. Also known as following the herd and buying last year's winner. And, of course, panicking and selling as the markets drop.

• Infrequent or irregular portfolio re-balancing, resulting in an asset mix that no longer aligns with the initial investment objectives.

• Frequent trading, which can drive up trading costs and trigger capital gains taxes.

What should an investor expect from their portfolio returns? They should expect that the returns are consistent with their long-term investment objectives.

This means the most important numbers on the report, if they're available, may be the three-year, five-year or 10-year annualized returns.

Don't have any long-term investment objectives, you say? Perhaps now's a great time to create some.



WHAT'S A REALISTIC RATE OF RETURN ON AN INVESTMENT PORTFOLIO?

That's a question many investors across Canada will be asking after reading their most recent performance reports from their advisors.

Thanks to new rules introduced by Canada's securities regulators, reports should include portfolio return for the past calendar year and since inception. (With longer-term figures required starting 3, 5, and 10 years from now, respectively.)

Some investors may be left feeling disappointed, if not in a state of shock. They could be further exacerbated by listening to someone boast about his or her double-digit investment wins, or simply one's own potentially unrealistic expectations.

Others may be disappointed when comparing their portfolios to the broad market indices. For example, Canadian stocks returned 21% in 2016. US stocks, 12%.

Take heart. Comparing personal portfolio returns to the broad indices is a mug's game. Market indices do not consider the impact of taxes, trading costs and fees, and cash flows in and out of the portfolio. The TSX Composite Index and the S&P 500 Index mirror a basket of stocks 100% invested 365 days of the year. There are no bonds and no cash.

CONCLUSION

Financial advisors are changing the way they do business. Instead of earning commissions for placing products, they are increasingly charging fees for rendering more professional services. In the process, they are putting the interests of their clients ahead of the interests of their employers and product suppliers.

The industry is being challenged to remain relevant. People are living longer, but careers are less stable, and returns are expected to be significantly lower going forward. As a result, most investors will likely work longer before retiring and re-calibrate to a more modest lifestyle than they might have previously expected.

Expectations almost certainly need to be lowered…. and advisors and the firms they work for need to manage costs like never before. In the past, people might have been able to retire in comfort if markets returned 10% and products and advice combined to cost 2.5%.

In a world where returns might be more like 6% going forward, an all-in cost of 1.5% is likely more appropriate (and necessary).



All of us face risks every day. Some are larger risks than others, but they still exist. Even though we face daily risks, most of us do not feel we are in danger. We expect the auto fatality to happen to that mysterious "other person.” We try to be careful in our homes to prevent loss from fire. We do not expect to be disabled and unable to work. That does not mean that we cannot die in an auto accident, or have a house fire, or become disabled. We just do not expect it to happen to us.

Few people really think about the risks in their lives and this is the way it should be. No one could be productive if they were paralyzed by fear. Even so, most Canadians do use insurance to minimize their risks. We also generally recognize some of the risks we take in our investments. Recognizing risks and doing what can logically be done to minimize them has become an accepted part of life. Although we may not realize it, most Canadians are involved in risk management. The objective of risk management is simple: minimize risk or transfer risk to another. Although we do not state it, our purpose is to maximize productive efficiency by bringing about a balance between financial resources and the possibility of a financial loss. We want a balance between premium costs and the protection it offers.