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Understanding the Beta Principle: A Brief introduction to Risk Management in International Markets.

By George L. Salis

13 August, 2007

"Chance is always powerful.  Let your hook be always cast.  In the pool where you least expect it, there! Will be a fish."

                                                                                                                        Ovid

The only permanent and most significant constant inherent in all investing, is risk.  We all enjoy our return on investment, as we all like to win and multiply our holdings, yet few investors, whether domestic or international, really understand the nature of risk.  Risk is an intrinsic element in all markets.  Regardless where one invests, or the type of investment made, the element of risk is always present.  Risk can be characterised as that "measurable" possibility of losing or not gaining value [or profit].  This is significant because risk has to be distinguished from uncertainty, which cannot be measured at all.[i]  It is also more than just a mere "chance of return, as a chance is an un-measurable possibility, whether accidental or incidental, in the strictest sense of the term for our investment purpose. 

Just as we all always ready for gains, we must equally face the possibility of loss in any market position.  The market is an uncertain and it is unstable place. It is volatile and risky in and of it-self.  The best way to confront this element of risk is to identify the risks, and measure and calculate it, so that it can be managed effectively, and best of all, profitably.  Few of today's lay investors truly understand the nature and the nature of risk.  Many investors heavily rely on institutional investment professionals to advise and manage all the diverse aspects of their investment, but even few of these professionals comprehend the diversity of the risk involve.  Fewer still, know how to measure risk, and in fact, many of them probably delegate and expect other "money and fund managers" to institutionally supervise the risk for them and their clients.  Every investor should at least understand the basics of risk management, but more particularly, the international investor should be more than just quaintly familiar with how risk works, both for and against the investor.

As I have discussed before in other articles in this Journal, true asset protection has more to do with investment, financial planning, and estate and tax planning, than anything else[ii].  Any other form of asset protection having to do only with complex multi- levelled jurisdictional structures of legal entities designed merely as holding companies or asset stores, in order to shield these from creditors and/or for tax avoidance purposes, is simply ineffective in our present day.  In today's world, full of strict "Revenue" compliance rules, coupled with heavy penalties, and political and judicial suspicion towards the "offshore" investor, holding companies, trusts, and even partnerships, for the sole purpose of cloaking assets or income, is impractical and even treacherous.  A valid, profitable, and progressive asset protection plan includes financial and investment planning, portfolio management, tax and estate planning, as well as a rigorous risk management and aversion plan. 

It is when you organise your portfolio in a risk and asset diversified manner, that the investor traverses the threshold from asset protection, to wealth management and preservation.  It may seem like just labels, but it is not.  Whereas the former is limited to merely the protection of the assets, the latter is progressive, it is growth oriented, and risk- diversified, and is truly protected through asset allocation.

Recently, I attended a scholarly conference were I sat as a member of a two selected panels having to do with international economics and global investment. There was much discussion on global and regional economics, wealth distribution, tax equity, foreign exchange rules, etc.  As I suspected, when the topics of foreign investment and market diversity arose, so did the un-avoidable topic of offshore finance and investment, jointly with the ever-present tax avoidance issues.  After it was all over, one fellow panellist which is a current sitting state judge in a northern US state, approach me and stated,  

"...all this talk of foreign trusts and offshore this and that is useless.  If a trust is good and its purpose and structure is well- founded, then there is not problem, anywhere.  No matter how good the structure, or the scheme seems to be, as a judge I have one weapon to compel compliance and good faith; the court's power of contempt.  With this [legal] mechanism I can make any defendant comply, and return to our shores even the most remote trust, company, or funds and it will re-appear within days.  In such cases, we [judges] must make the use of our contempt of court authority to ensure compliance."

Not wanting to argue with a colleague, I simply nodded my head in confutation, and recognized the tenacious and permanent power of a court to enforce its judicial determination.  Even when lawyers can subsequently mount challenges to these contempt powers, it can take much time and resources from the client.  However, I think her attitude illustrates quite well the present attitude and even suspicion by the bench, of the "offshore" investments, IBCs, and trusts.

This Notion of Risk...

The problem here is that many (self-styled) offshore providers, consultants, and other professional may not fully understand how international markets really work, and how the international economic system functions.  This is utterly perilous when one takes into account that trustees, bankers, and other professionals carry with them the power and duty, to invest their client's assets, and that not all of them can readily discern the abundant variety of risks inherent in  regional, industry, domestic, and trans-national markets.  In times of global market instability, such as the one we are currently experiencing, can the international investor afford not to be aware of the process of risk assessment and management?  Personally, I think not.

Regardless, whether you call yourself an "offshore" investor, or global or international investor, it all really means the same thing.  What it means is that you do not only invest in domestic and/or regional markets, but that you rather, participate in foreign markets as well.  The difficulty here is that for many investors, the label "foreign" actually conveys negative implications and inferences.  This negativity arises with the unfounded phobia that some markets are much riskier than others at "all times," and in particular foreign markets.  To the "protectionist" styled investor, the term "foreign" means not only abroad, but also, adverse, strange, alien, unstable, and above all; unreasonably risky.  Certainly, this is all nonsense, as all markets today are highly trans-nationalised and integrated due to the intensification of the global economy.  Moreover, many investors in industrial nations falsely assume that non-domestic or regional markets must be riskier, because these are, or may be, developing or emergent markets.  This also is another false assumption, as true international or global investor may select anyone industrial market, or a combination of over twenty-three, fully-developed global markets.[iii]

All markets have their periods of ups and downs, of gain and loss.  This is not unique to any one foreign or domestic market as there are multiple external (fundamental) and internal (technical) factors influencing the global market at any one time.  Depending on specific market condition and its timing, all markets have their steady and reliable growth seasons, as well unstable periods of retraction.  Nevertheless, all markets are intrinsically volatile.  In fact, it is this constituent volatility that makes markets a risky place, to which some investors earn grand profits, while others may loose even their account margin.  It is all a matter of timing, market or industry preference, investment strategy, and risk aversion planning.  Nevertheless, each investor individually must always find its own Beta threshold, that is, its very own level of risk tolerance.  The duty of each investment professional, regardless of title or profession, is to inform and assist the investor in determining exactly what that particular level is.

Simply defined, risk aversion is the assumption that any sensible investor, given the same rate of return and different risk alternative, will always seek the best investment offering the least amount of risk.  In other words, any rational investor understands that the higher the degree of risk in the investment, the greater the return that the investor will demand.  The modern global investor must be aware of the many different kinds of risk which are intrinsic to international markets.  It is such (informed) awareness that allows each investor to participate fully in her/his portfolio planning, market and product selection, and the process of asset allocation.  Therefore, in this manner, the investor will become a proactive contributor in the process, and not merely a passive bystander or reflexive observer, which allows the adviser to manage completely its assets, and thus, to make decisions without his informed consent, or further input.  The educated and alert global investor should be an active, synergetic supplement to his investment professional, and not simply an acquiescent signatory to his own investment plan, complacent and submissive to all the would- be market moves that some institutional money manager or broker, wishes to assign.

The key to a well balanced portfolio is diversification.  Portfolio equilibrium is only achieved when an investor is well- diversified and the risk is spread efficiently through the selection of a variety of investment vehicles, products, mutual fund companies, industries, and market position(s), which are tailored to the precise objectives of the investor.  Therefore, in theory and practise, the more diversified investor is, the better balanced his/her holdings are. One must keep in mind, however, that any unexpected event(s) can occur in any market, at any time that may have an effect on the balance and value of the portfolio, whether positive or negative. At any rate, the well-diversified investor will always be ahead of the rest in portfolio performance. 

Investment portfolios should be designed according to the particular investment strategies of the investor, and with risk aversion preferences.  Fundamentally speaking, there are two main types:  a) an aggressive investment strategy - which is designed for maximum returns through undertaking greater risks in order to obtain greater returns.  This approach seeks to buy or make speculative, high-risk investment in "growth-oriented" industries or sectors, and short-term trading tactics and profits that are coupled with a high portfolio turnover, and, b) a defensive investment strategy - is one that seeks to minimise risk, conserve capital / funds as reserve, and provide stable and fixed income.  This type of conservative strategy seeks long-term and highly stable investment in older and well established companies that offer greater security, through income producing bonds, convertible securities, and even metals and precious stones, during recessionary cycles.

Primarily, there are two categories of measurements of risk to consider.  These are the Alpha and Beta Coefficients.  Investment professionals and economists always measure risk in terms of the probability of return, considering specific conditions or factors in correlation between the investment made and the present market conditions.  Briefly stated, the Alpha (α) coefficient measures that portion of an investment's return arising from a specific / non-market risk, such as the value of the share of stock over time, or the growth in earning per share, or on any investment.  The Beta (b) coefficient, measures an investment's relative volatility in the marketplace.  It is a rational comparison of an investment in a particular market in relation to that market as a whole.  Hence, defensive or conservative investor with a low level of risk tolerance, aiming at capital preservation, should focus on investments with low Betas, whereas aggressive investors seeking higher returns with high risk tolerance should concentrate on high Betas type investments.

Regardless which of these strategies an investor chooses to follow, the portfolio should always reflect and serve the investment attitude and the risk tolerance of the individual investor.  There are other sub-categories of portfolio design, which are too numerous to cover in this short introduction to risk, but these two are the basic ones to keep in mind, as they are directly related to risk management, asset allocation, and market selection.

The various kinds of Risk...

When considering a risk management plan, there are various types of investment risks that the investor should be attentive to.  Principally, these are:

1)      Economic Risk - This is the leading "inter-active" analysis of risk to be considered.  It involves the assessment of the potential uncertainty of current global events that make up the "fundamental" consumer trends and cycles, such as the global and regional economic troubles, social (or anti-social) events affecting trade and commercial policies, as well as present shifts in trans-national politics, etc.  This is where the economic, social, and political sectors that are influencing the globe converge.  Each one having a direct cause and effect on the other, and each having exact consequences on the world economy as a whole, including the markets.  Of course, this will also have a profound effect on the quality and performance value of your individual portfolio, again, in either a positive or negative manner.

2)      Market Risk - This is also known as Systematic risk.  This is the basic type of common risk which is inherent in the market itself.  It is an inherent part of investing and market participation.  This type of risk, although it can be managed, it cannot be eliminated or decreased even through diversification.  It is common to all types of investments due to the volatility and unpredictability of the marketplace.  The only way to eliminate it is to not invest at all, which defeats your diversification plans and increasing the expected rate-return objective. 

3)      Financial Risk - Also known at times as Credit risk.  This other type of risk is also inherent in all business and investment ventures.  It is the uncertainty that comes from the future of the company or organisation that issued the security or debenture, etc.  It concerns the "stability" of the company who issued the stock or bond.  The financial future or internal stability of a company cannot be predicted with any degree of certainty by outsiders, and therefore, its performance cannot be guaranteed.  Neither can the price of its stocks, bonds, or its continuity be assured.  This type of risk affects all companies, securities, derivatives, and debentures, including mutual funds as well. 

Conceptually, an investor should understand that risk assessment is further divided into two main and separate categories.  As mentioned before, these are risks that are internal to the specific market, industry, and/or type of investment (technical) and those risks which are external (fundamental) to those markets, such as war, scarcity of a commodity, political changes, natural catastrophes, climate changes, social and policy shifts, labour strikes, changes in laws and regulations, etc.

These three types of risk listed above are the principal "collateral" risks that any global investor should be aware of, together with the derivative manifestations that usually flow from one or more of these.  Although, for brevity's sake, we cannot delve deeply into the many elements and categories of risk, investment professionals and investors are well advised to become aware of its cause and effect.  The "awakened" global investor should also mind the forces and impact of other forms of risk such as: re-investment risk, currency / foreign exchange risks, interest rate risk, market-timing risks, inflation risk, liquidity risk, taxation risk, management risk, and legal risks, etc.

In addition to these, there is one very significant kind of risk which the investor should become acquainted with, particularly, given the political climate in our world today and its corresponding social unrest.  This is of course, is the Sovereign or Country risk.  Sovereign risk is defined as that risk that a foreign government may default on its loans or fail to pay its international debt obligations, and honour business commitments which are due to changes in national policies[iv]. 

This type of risk may not only include national inflationary and recessionary risks, but may also consist of potential forfeiture of assets by governments, onerous restrictions of foreign exchange rates, high protectionist tariffs, restriction on the export of capital, trade restrictions, prohibition on repatriation of company funds, nationalisation of private assets and property, confiscation of business interests, cancellation of (foreign) credit and contracts.  The recent events and the situation in Argentina and Venezuela readily come to mind, as do past events in Cuba, Nicaragua, and other European countries during the last century.  This is central here because the investor should not only take into account where the investments are located, but should also consider wisely the effective place of management of the investment portfolio, and from where it will be managed.  Consequently, it is also imperative that investors chose carefully both the managing investment professionals and the jurisdictions where they are located.

After all this...why invest in Global markets?

As indicated previously, many investors are under the mistaken notion that investing abroad is riskier than investing domestically.  Not true. The fact is that investing abroad carries the same risk as investing domestically and sometimes even lower.  Of course, there may be some variance of risk from market to market and country to country, i.e., such as risks innate in different market regulatory systems or the risk of weak investor-protection laws, or foreign exchange controls, etc.  But in the end, an investor seeking a greater rate of return must accept higher risks, regardless of the market where he or she invests, as the key to risk management is efficient diversification and asset allocation.  The modern global investor should recognise that geographical / market spread and asset allocation is essential given the uncertainty and unrest of our world today.  As the globe is now an ever-shifting and increasing global economy, allocation and diversification are perhaps more momentous today than market timing, seasonal trading, spreads, or even securities or investment selection.  Diversification and allocation are the best performance indicators and / or determinants of the progressive investment portfolio. 

Therefore, economically speaking, it is a matter of fact that global investing actually reduces risks, rather than increasing it, as asset and market allocation, coupled with cross-market and diversified financial products will further reduce many elements of risk, whilst at the same time increase the rate of returns.  When it come to international investing, the effective modern investor has to cease thinking in terms of "foreign" and start expanding her/ his profit horizons, by shifting its perspectives in terms of "global."[v]

A Final Word

Risk management should be of paramount concern for any serious investor.  Whether you call it international investing, foreign, "offshore", or global investing, it is actually all the same thing.  What truly matters is broader market diversification, expanded asset allocation, and a systematic plan of risk management.  Investors should seek properly qualified investment professionals to help them seek the best market opportunities, to provide advice high-performance financial vehicles, and assist them in managing risk more efficiently.  It is the cooperation and synergy between professional adviser and informed investor that allows for the finest investment decisions to be made and increase, (even higher still!) the probability of return. 

I like to leave the reader with one last thought that perhaps illustrate best the willingness to dare and to take on risks.  In his book, "Against the Gods - The Remarkable Story of Risk," which is the book that I consider to be best studies on the subject of risk management and risk analysis, for the investor who has the time, and wishes to become immerse in the subject, economist Peter L. Bernstein writes:

            "The word ‘risk' derives from the Italian risicare, which mean ‘to dare.'  In this sense, risk is a choice, rather than a fate.  The actions we dare to take, which depend on how free we are to make choices, are what the story of risk is all about.  And that story helps define what it means to be a human being."[vi]

Many Happy "Returns"...

Dr. George L. Salis

www.JurisConsultsGroup.com

* © All Rights Reserved 2003.

**Dr. George L. Salis, is a university professor, and both a lawyer and economist.  He has taught law and economics in various colleges in the US and abroad.  Formerly the Dean of Academic Affairs at Keiser College- Lakeland, he is now the Programme Director for the Legal Studies Department for all campuses of Keiser College.  He is also a Principal in JurisConsults International Group, an international consultancy, specialising exclusively on matters of international investment, taxation, arbitration, trade, and economic law providing services to law firms, banks, companies, and investment professionals around the world.   He is also a frequent speaker in the international professional conference circuit.

[i] Barron's Finance and Investment Handbook, 5th ed. Edited by John Downes and Jordan E. Goodman., Barron's Educational Series, New York, (1998).

[ii] See Asset Management Strategies for Financial Growth: basic guidelines for aggressive offshore investing, Issue 108 Offshore Investment, Part I, July / August 2000. See also, Effective Asset Allocation equals total Protection  Issue 109, Offshore Investment , Part II, September 2000.

[iii] Robert P. Kreitler, Getting Started in Global Investing, John Wiley & Sons, New York (2000), at pg.18-19.

[iv] Barron's Finance and Investment Handbook, at 603.

[v]Note: For a more in depth view of "shifting" from a captive domestic investor to becoming a modern global investor, see Getting Started in Global Investing, by Robert P. Kreitler, John Wiley & Sons, New York (2000).  This is an excellent little book of great introductory value to any investor ready and willing to make the "shift."

[vi] Peter L. Bernstein, Against the Gods - The Remarkable Story of Risk, John Wiley & Sons, New York (1996), pg. 8.

About the Authors

B.Sc., LL.B.(Hons), M.A., LL.M., Ph.D.,**
JurisConsults International Group, Florida,USA
Programme Director, Legal Studies Department, Keiser College Orlando, Florida.