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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 portfolio.

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.

Risk Type Description

Market Timing

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.

Aggressiveness

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.

Diversification

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.

Inflation

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.

Risk Tolerance

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.

Risk Reward Graph
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