Managing Risk in Investing
Investing is full of risk. Companies go out of business,
political changes affect markets, bubbles come and go,
Ponzi schemes claim millions, and your portfolio is
vulnerable to all of them. The goal of any asset
allocation plan is to find a level of risk that you are
comfortable with. There are several types of risk, each
of which can affect your portfolio. By understanding the
risks associated with financial investing, you can
consciously avoid them or mitigate their impact on your
One key to building a successful investment portfolio is to eliminate the risk you
can control and reduce the risk you can't.
Bill Schultheis, The Coffeehouse Investor
What risks are there in Asset Allocation planning?
The stock market goes up and down. Companies go out of business. Real estate markets
collapse. The unemployment rate goes up while the prime rate goes down and no normal
person can keep track of everything when there are bills to pay, jobs to go to,
and kids to pick up. Every investment has some type of risk associated with it.
With stocks and other equities, you run the risk of trying to time the market for
a quick profit. Maybe you believe the next Great Depression is on the horizon and
put all your money in low-yield, safe savings bonds and risk not being aggressive
enough. Or maybe you believe the next bubble really is different this time and invest
everything in one sector and risk not being diversified. The idea behind asset allocation
is to spread out your risks and understand how much of an impact any one of them
could have on your portfolio.
Attempting to buy or sell at an advantageous time to generate a quick profit. The
Efficient Market Hypothesis suggests this is virtually impossible without insider
information or incredible luck.
Holding assets that are either too aggressive or not aggressive enough to meet your
needs. This may result in reacting to market volatility with an emotional response
rather than making a financially sound choice.
Holding too much of any one asset class may negatively impact your portfolio. Just
as with the tech boom, explosive housing growth, and hedge funds, there is always
a bubble and people getting burned when the bubble inevitably bursts.
Over time, things become more expensive. As inflation grows every year, your investments
must exceed the rate of inflation or else you are not gaining any real money.
While markets are complex machines of numbers and symbols, investing is ultimately
an emotional decision. Understanding how much risk you are willing to take is essential
to determining what your asset allocation plan will look like. Are you willing to
take high levels of risk for potential high rewards? Even if that means your portfolio
may drop dramatically some years? Can you resist the urge to cut your losses and
sell poor performing funds even though they may do well in the long run? Can you
rely on other savings accounts to provide you money for emergencies or will you
dip into retirement accounts?
An aggressive investor is the type of person willing to invest in high risk assets
hoping to receive high rewards. A conservative investor will never like to see an
asset class losing value and may sell at a loss. Determining what type of investor
you are helps you understand what types of stocks and bonds you should be putting
into your account as well as the proportion of stocks to bonds and cash.
If you are unsure what type of investor you are, there are many quizzes online to
help you. While each one may be slightly different, you should get a good feeling
for your investment style.
Choosing assets to match your risk tolerance
Different assets can be grouped into different risk categories. While cash and government
bonds may be virtually risk free, stocks in small business run the risk of the company
going out of business every day. Once you understand your risk tolerance, you can
begin to choose what types of assets you want to have in your portfolio.
While every portfolio should spread assets across asset types, it is also important
to spread out the assets across risk categories. While an aggressive investor with
a long time horizon may tilt their portfolio to have more mid and small-cap funds,
they should still have large cap, bonds, and international to spread out the risk.
While not every investment has the same risks as the asset class it is in, here
is where investment classes typically fall in terms of risk.
Next: Planning for your Asset Allocation Plan
Page last modified 3/21/2012