“No pain, no gain”; “nothing ventured, nothing gained”; “there’s no free lunch;” “no risk, no reward”… We can all probably think of dozens of proverbs and stories that all make the same point: in order to get almost anything worthwhile, some element of risk must be accepted. It’s true in almost all areas of life. Think about it: Did it feel risky, the first time you asked that special someone out for date? Just about every new parent can also affirm that when you first hold that newborn in your arms, you’re thinking about all the risks involved in raising and caring for the child. And anyone who has launched a new business knows that various types of risk are a constant.
Of course, risk is a part of the financial markets, as well. In fact, it’s an essential element, because the expected return on any investment is a function of how much risk the investor is accepting. The more risk, the greater the potential return. And it’s also true that there is more than one type of risk. Market risk, or the potential for value of an asset to rise and fall, is the one we hear about the most; it’s on display every time the stock market goes up or down But there are other types: interest-rate risk, inflation risk, currency risk, credit risk, event risk… and the list goes on. The fact is that there is no investment of any type (including bank CDs and US Treasury bills) that is completely free of all types of risk.
Can investment risk be managed?
So, if risk is everywhere, what should investors do? The good news is that risk, while it cannot be completely eliminated, can be managed. Not only that, but portfolios can be constructed in a way that can reduce risk while also positioning the assets for future growth. The key is to provide for managing risk in the portfolio in a way that coincides with the investor’s needs, position in the investment life cycle, and ability to tolerate the amount of risk that matches with the potential reward the investor hopes to achieve.
Strategies for Managing Risk
1. Risk planning. The first step is for the investor to establish a plan that includes an understanding of the investor’s goals, what is required to reach them, the amount of risk the investor is able to accept in order to reach the goals, and an assessment of the types of investments that can meet the investor’s criteria.
Risk planning should involve extensive consultation with the investor’s financial advisor to determine the investor’s risk profile (how much risk the investor is willing to accept), goals, and values. From these parameters, the investor and the advisor are in a position to evaluate what sort of investments are needed to reach the goals that are also within the parameters for risk and reward that best serve the investor.
Depending on the goal and the time needed to achieve it, various types of assets may need to be considered. For example, someone who has only a short time frame until retirement may wish to accept only a moderate amount of risk and therefore might be best served by assets with a lower risk profile, such as high-grade corporate and municipal bonds or US government securities. On the other hand, a younger person who has twenty or more years to retirement may be willing to accept a somewhat higher element of risk, since they have more years for their assets to grow and must also be concerned about the risk posed by inflation to their future purchasing power. They may benefit from holding a selection of equities (stocks) or equity mutual funds.
The point is, risk planning starts with a thorough understanding of the investor’s needs, goals, resources, and ability to tolerate various types of risk. Once these are known, portfolio design can proceed from a more solid foundation.
2. Asset allocation. Once risk planning is accomplished, the investor and advisor are in a position to select the various assets and allocate them to the portfolio in the appropriate ratio. Asset allocation is where “the rubber meets the road” with respect to matching the investor’s risk profile with the portfolio holdings. To return to our example above, an investor who is retiring and mostly in need of a secure current income stream to supplement Social Security, pensions, and other retirement benefits may benefit from holding a larger percentage of the portfolio in assets with less market volatility that generate interest or other income. The younger individual, on the other hand, may benefit from allocating a larger percentage of the portfolio to assets with greater long-term growth potential, such as stocks or stock mutual funds.
Another point is important here. Even investors who are nearing or in the early years of retirement should consider allocating some portion of their portfolio to investments with growth potential. Why? Because people are living longer, and even older investors are likely to need for their money to grow at a rate faster than inflation in order to ensure future sources of funds and sufficient purchasing power. In fact, the Pew Research Center estimates that the number of US citizens age 100 or more is expected to quadruple over the next 30 years. This means that more and more Americans can expect to live 30, 40, or more years in retirement. In other words, inflation risk should be taken into consideration by most, if not all investors.
3. Diversification. This is one of the investor’s best and most effective tools for managing risk. By diversifying their holdings among various asset classes, investors can benefit from a wider range of growth sources. Just as important, they can reduce the effects of temporary losses in one part of the portfolio by potential gains in another part.
Building a well-diversified portfolio means allocating assets that have low correlation: they are affected differently by various market and economic forces. For example, growth stocks (like Amazon, Nvidia, and other big tech companies) are very sensitive to interest rate movements because of the amount of money they need to sustain their growth model. On the other hand, consumer staples (like Procter & Gamble, Walmart, or Coca-Cola) are often less affected by interest rates. So, when the Fed announces a rate increase, growth stocks may often decline in price, temporarily. Consumer staples, on the other hand, may decline only by a smaller amount, stay the same, or perhaps even increase slightly, as traders exit growth stocks in favor of a more attractive category. Other examples of holding assets with low correlation would include investors who have a percentage of assets in equities and another sector dedicated to fixed income (bonds, bond funds, and other interest-bearing assets).
By planning for and managing risk, investors are more likely to reach their most important financial goals. Using the tools above and others, they may be able to both reduce the effects of various risks and, over time, achieve available gains in value.
Your GEM Asset advisor can work with you to understand and plan for both the risk and the reward parameters of your investment portfolio. We are here to answer your questions and provide evidence-based guidance.
