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Risk is everywhere: Know where you stand

The common wisdom on investing risk is that things go down as well as up, but in the long run you win.

If you're happy with that level of understanding about the hazards of being in the stock market, that's fine. But if you've watched the market gyrations of the past week and want to know more about the potential danger spots in your portfolio, then read on because this edition of the Portfolio Strategy column is all about risk.

We'll run some risk diagnostics on the kinds of investments that Canadians hold, and we'll look at how diversification can reduce the dangers of being exposed to markets such as China, where the stock market fell more than 9 per cent on Tuesday. At the end, you should have a better idea of how your portfolio would hold up in the event of a sustained market downturn.

Our risk analysis tool is one of the most useful and sophisticated websites available to investors, RiskGrades (riskgrades.com). This site is offered by a company called RiskMetrics Group, which advises more than 650 worldwide banks, pension funds, hedge funds and money managers. Individual investors can use RiskGrades at no cost, so don't hesitate to make use of its extensive database of U.S., Canadian and global stocks to evaluate your own holdings.

RiskGrades uses a rating system that examines how much variation there is in a stock's price -- recent moves are emphasized -- and then assigns an ever-changing numerical score ranging from zero for risk-free cash to as much as 1,000 or more for superspeculative investments. Using RiskGrades, you can accurately asses the comparative risks of investments in individual stocks and stock indexes, no matter what country they're from. You can also assemble portfolios and compare the overall risk with the individual components.

In a sensibly built portfolio, the risk of individual holdings is less important that the overall portfolio risk. RiskGrades makes this point clearly when you look at a balanced portfolio evenly split between stocks and bonds.

The stocks portion was made up of roughly equal holdings in three exchange-traded funds, one of which covered Canada's S&P/TSX composite index, one the S&P 500 stock index and the other the Morgan Stanley Capital International Europe Australasia Far East Index. The bond portion was composed of another ETF that covers the Scotia Capital Universe Bond Index, which is a benchmark for the entire Canadian bond market. ETFs were chosen for this exercise because they're stocks that allow investors to capture the returns of various stock and bond indexes.

The most hazardous holding in this basic but sound portfolio was the EAFE fund, with a risk grade of 79 as of late this week. The S&P/TSX composite was next at 59, the S&P 500 scored a 67 and the Canadian bond ETF scored a 20. Mixed together, these ETFs earned a risk grade of 31. As we'll see, that's quite a good rating.

Let's ramp up the risk level a bit now by moving to 75 per cent equities and 25 per cent bonds. This takes the portfolio risk score up to 46, which suggests that halving your bond exposure boosts your portfolio risk by a roughly equivalent amount. It should be no surprise, then, that eliminating bonds altogether raises the risk score to 61.

Now, what about some of the risky stuff that people have been investing in lately? Things such as China and emerging markets, for example. Using the applicable ETFs, we get a risk rating of 206 for the Chinese market and 143 for emerging markets in general. European stocks get a 93, while the Japanese market alone gets a 74 and the hot-performing Mexican stock market gets a 151. You prefer to speculate on technology rather than exotic markets? Stocks in the Nasdaq 100 index get a risk rating of 82. You like gold? An ETF acting as a proxy for gold bullion has a score of 100, while a crude oil ETF is at 156.

These risk numbers are, in a way, irrelevant because few people invest only in highly speculative things. The saner way is to sparingly mix them into a well-diversified portfolio, which keeps risk tamped down.

To see this effect in action, imagine adding a 5-per-cent weighting in the Chinese market to a portfolio that is 25 per cent invested in bonds with rest in Canadian, U.S. and international stocks. Without China, the risk score is 46; with China, it's 51.

Is that extra risk worth it? It's tempting to say yes, given that the Chinese market more than doubled last year. Just remember that China's risk score reflects not only this week's dip, but also the huge gains of last year. In other words, China's probably riskier than it appears at first glance.

Typical Canadian investors have large parts of their portfolios invested in domestic stocks, and that's a good move as far as risk is concerned. As we've seen, RiskGrades has assigned substantially lower scores to the Canadian market versus the U.S. and international markets, not to mention emerging markets.

Want to reduce your risk in the Canadian market even further? Think dividend-paying blue chips. There's an ETF that tracks TSX-listed stocks with strong dividend yields and it had a risk score of 42. You don't get exposure to much in the way of energy and metals stocks with this approach, but you do get a clear measure of stability.

It's often said that health care and consumer staples are sectors that hold up well when the markets get rough. Let's test that by looking at what RiskGrades has to say about U.S.-listed ETFs that track these sectors. There's a consumer staples ETF with a risk rating of 42, and a health care ETF with a rating of 60. These scores don't suggest an outstanding level of risk reduction, but they're a lot better than holding some individual stocks in the consumer staples and health care sectors.

Pfizer Inc. and Merck & Co. Inc., two pharmaceutical giants, had risk scores close to 100, as did the troubled grocery chain Loblaw Cos. Shoppers Drug Mart Corp. scored a 74, while Rothmans Inc. got a 104.

RiskGrades also has some interesting things to say about the relative dangers of holding the country's largest stocks as measured by market capitalization (that's shares outstanding times share price). The big banks offer the least risk right now, with risk ratings in the area of 45 to 65. Energy companies are about three times riskier and Research In Motion Ltd. beats 'em all with a rating of 210.

Just as there are gradations of risk in the stock market, there are also differences between various types of bonds. RiskGrades shows this through its ratings on a trio of TSX-listed ETFs that track subindexes of the Scotia Capital Universe Bond Index, which is used to measure the performance of the entire Canadian bond market.

As we've seen, the broad bond market gets a risk score of 20. Short-term bonds, which are less volatile but also offer lower yields, get a rating of 12. Real-return bonds, which are designed to offer a premium over the inflation rate, get a rating of 29. You'll notice that all bonds score better than stocks on risk, a point not to be ignored right now.

Grading Risk

The website RiskGrades compares the risk levels of stocks from Canada and around the world using a scale that starts at 0 for super-safe cash and rises according to how much volatility a stock has shown. Here's how various stocks and stock indexes stack up.

WIDELY-HELD TSX-LISTED STOCKS
Alcan Inc.161
BCE106
Barrick Gold119
Bank of Montreal 52
Brookfield Asset Mgt.123
Canadian National Railway 99
CIBC 65
Canadian Natural Resources141
Enbridge 65
EnCana115
Great-West Lifeco 77
Imperial Oil136
Manulife Financial 73
Research in Motion210
Rogers Communications129
Sun Life Financial 73
Thomson Corp. 72
TransCanada Corp. 63
SELECTED GLOBAL STOCK INDEXES*
Dow Jones Industrial Average 64
FTSE/Xinhua China 25206
MSCI EAFE 79
MSCI Emerging Markets143
Nasdaq 100 82
S&P/TSX Composite 59
S&P/TSX 60 61
SECTOR OR SPECIALTY STOCK INDEXES*
Dow Jones Canada Select Dividend 42
S&P Select Sector Consumer Staples 42
S&P Select Sector Healthcare 60
S&P/TSX Global Gold144
S&P/TSX Capped Energy 99
S&P/TSX Income Trust 86

*ratings are based on exchange-traded funds that track these indexes

SOURCE: RISKGRADES.COM

© 2007 The Globe and Mail. All rights reserved.

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