Investment
risk is real. During a bull market when seemingly
every investment is appreciating, risk is
often overlooked. But when risk finally "shows
up" during a market downturn, the results
can be truly devastating. Many investors have
recently discovered, to their dismay, that
their portfolios were far more aggressively
invested than they realized.
On the other hand, some investors fail to
take enough risk in their portfolios and fail
to achieve the asset growth they need to accomplish
their goals. Because inflation is the greatest
investment risk for retired fixed-income investors,
we normally counsel them to diversify with
a modest equity allocation.
We work with each client
to determine the appropriate level of risk
based on individual goals, preferences, and
circumstances.
We know from Modern
Portfolio Theory that risk and reward are
related. The reward for taking more risk is
the potential of higher returns over time.
In portfolio design, risk is controlled primarily
by varying the weightings of (riskier) equities
versus (safer) fixed income instruments. Also
affecting portfolio risk is the exposure to
certain asset classes, such as small stocks,
value stocks, and emerging market stocks,
that are somewhat more risky than other equities.
We normally consider three main issues when
assessing the level of risk appropriate for
a client:
1. The ability to take risk. The
longer time horizon a client has, the more
aggressively the portfolio may be invested.
US stocks, for example, have never lost money
over a 30 year time period, though they frequently
have posted losses over shorter time periods.
2. The willingness to take risk.
Some investors are very uncomfortable with
portfolio volatility and the possibility of
significant short-term losses. Higher investing
returns are never worth losing sleep over.
3. The need to take risk.
Older, wealthier investors who already have
a portfolio sufficient to easily meet their
goals do not need to take high risks with
their money. The preservation of capital may
become the paramount objective.Types of investment
risk
Many authorities define risk differently.
These are the risks we consider when advising
clients:* Failing to meet your life goals.
(In our view, the most important risk.)
* Portfolio volatility.
* Inflation risk.
* Interest rate risk.
* Concentration in a certain company, industry,
or asset class.
* Value stock risk (associated with investing
in distressed or highly-leveraged companies).
* High correlation with non-financial assets,
such as home value and employment.
* Investment manager risk. (Not a factor in
passive investing.)
* Performance not tracking the major US market
indices.
Some of these risks
can be largely eliminated by broad, global
diversification. Other risks, of course, can
only be reduced by reducing one's exposure
to equity investments.
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