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Posted on JUL 10, 2017

Johnson Bank Wealth Weekly Investment Commentary | Monday, July 10

This is part of an ongoing series of Weekly Commentary articles published by Johnson Financial Group.
This week's issue is written by Brian Andrew, SVP, Chief Investment Officer.

Moms and Risk Management

This weekend I wanted to upgrade my son's skateboard from the cheap big box store brand to the specialized skate shop variety. The new board is easier to ride because it is wider and rolls better (i.e., faster). After 30 minutes in the driveway and a lot of exclamations about how much better it was, Mom put a damper on the fun, saying it was time to get some wrist guards, elbow pads and knee pads. After I headed back out and found the required padding, my son suited up. Five minutes later, he was back in the house telling his mother that skateboarding wasn't as fun and “Dad said when he rode boards he didn't wear any padding!” That's true, and yes, it was a long time ago. I'm not even sure they made that kind of equipment back then (pre‐Tony Hawk for those of you who are skateboard lovers)! In the area of risk management for our son, Mom would be on the more conservative side. I found myself asking this question: In the current market environment, should our portfolio risk management look more like Mom's or Dad's?

When the news media is sounding headlines about a “surge” in interest rates and a fall in bond prices, or “stocks are at all‐time highs, look out below,” it's easy to forget about how your portfolio is built to manage risk with your longer term objectives in mind. Let's review the risks that need managing, how these are managed, and whether now is the time for the Mom or Dad version of risk management.

Understanding Risk

Risk is something that can be hard to verbalize. There are several categories of it that we consider every day. Market risk is most important, in that it describes the price risk that comes with owning investments. It is the risk people are most attentive to when they review the market value of their portfolio from one period to another. We also think about liquidity risk, both in terms of our ability to get in and out of an investment, as well as what happens to price when everybody decides they want to do the same thing. Because a lot of our investments are fixed‐income oriented, we are also concerned with credit risk—that is, the return on and of the principal we've invested in bonds. Geopolitical risks are also a factor in our investments because we think about investing on a global basis. In the current environment, it is also important to consider tax risk. That is the understanding of how investments and their income production and gains are treated for tax purposes. In this new political paradigm, thinking about how taxes affect a portfolio going forward is top of mind.

All of these risks exist around a portfolio every day. Our job is to understand, measure and manage risks to ensure we are meeting our clients' objectives.

Managing Risk

The subject of risk management is one of the most complex in portfolio management. It is certainly more complex than we have the room here to explain, so I'll try to summarize our approach.

Many of the risks mentioned above can be managed by diversifying a portfolio. This implies investing in different kinds of securities in different markets around the world. It is why we incorporate different asset classes, including cash, fixed income, equities, real estate, commodities and so on. For some clients, diversifying also means investing in publicly traded securities as well as private or direct investments, and deciding how much of each of these to own. The decisions made around asset allocation govern the amount of market, liquidity and credit risk we take in a portfolio.

Building a portfolio starts with asset allocation because it is the best way to try to match the risk taken with the return desired. Think of it this way. Choosing the location of where you skate defines how much risk you take. Skating in the driveway or a parking lot is a lot different than skating in a skate park. It is akin to the argument about how much padding you need in the driveway versus the skate park.

Asset allocation changes for many reasons. Primarily, it changes because the risk tolerance one has for more or less market, liquidity and credit risk has changed based on a desire for investment return over principal protection.

Once the allocation to a particular class of assets has been made, choosing the specific security types assists with managing risk. This can be thought of in regard to my earlier comment about the big box skateboard versus the skate shop board. When I put the big box board down on the slight incline of the driveway, it doesn't move, whereas the skate shop board rolls to the bottom. The board choice is one way of managing risk. Mom would just as soon have not moved on to the better board.

Mom or Dad Risk?

The current market environment can be difficult for investors to get comfortable with. This is partly because the economy has been in slow growth mode for many years. When that happens, it feels like a recession is never too far away. In addition, while the labor market has tightened, wage growth remains a percent and a half or so from where it normally would be.

Couple that with a stock market that seems to go up no matter how much people say it shouldn't and low interest rates that cause people to say they must go higher, and you have a recipe for investor angst.

One thing is for sure. The U.S. stock market trades for a multiple of earnings that by any measure can be considered high. This level requires corporate earnings growth to deliver. If it does, then the market level can be supported. The market level also requires low interest rates, which we have. If they persist, then stocks may continue to trade at a premium level.

Interest rates are low for sure. They remain low because we have slow growth and low inflation. We have those things because global communications allow people to access the cheapest source of labor, reducing price pressure. The internet makes price discovery easier and lowers wages. Finally, the aging workforce in developed countries like ours lowers spending. As long as these trends persist, interest rates may remain below average.

More than likely your portfolio already has the Mom or Dad risk that is appropriate for the current environment. That risk was established when you met with your advisor and discussed your long‐term objectives. If the current environment makes you skittish, then revisit that discussion and determine whether your portfolio needs to shop for some wrist guards, elbow pads and knee pads.

Brian Andrew
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.

This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank, Cleary Gull Advisors Inc. and Johnson Insurance Services LLC. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE


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