We take risks all the time
Risk is everywhere, every day. Some people take steps to protect themselves and manage that risk. Others leave it up to luck.
The same holds true when it comes to building wealth for the future. Some investors focus strictly on returns and how fast they can grow their money. Others protect themselves against the inevitability of a correction or a bear market by using various risk management strategies.
That cautiousness doesn’t mean they’re paralyzed with fear, stuffing money under the mattress or sticking only to the safest investments they can find. The purpose of investment risk management is to ensure losses never exceed an investor’s acceptable boundaries.
It’s about understanding the level of risk a person is comfortable taking and building an investment portfolio with appropriate investments that also will work toward achieving that individual’s goals.
An investor’s risk tolerance is usually determined by three main factors:
Risk capacity: How much can the investor afford to lose without it affecting actual financial security? Risk capacity can vary based on age, personal financial goals and an investor’s timeline for reaching those goals.
Need: How much will these investments have to earn to get the investor where they want to be? An investor who is depending heavily on investments may be faced with a careful balancing act between taking too much risk and not taking enough.
Emotions: How will the investor react to bad news (With fear and panic? Or clarity and control?), and what effect will those emotions have on investing decisions? Unfortunately, this can be hard to predict until it happens.
Why is risk management important? Those who are able to preserve their capital during difficult periods will have a larger base to grow from when good times return.
With that in mind, here are some strategies investors sometimes use to manage the risk in their portfolio.
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1. Reevaluating portfolio diversification and asset allocation
You’ve probably heard the expression “don’t put all your eggs in one basket.” Portfolio diversification — allocating money across many asset classes and sectors — could help with avoiding disaster in a downturn. If one stock tanks, others in different classes might not be so hard hit.
Investors might want to consider owning two or more mutual funds that represent different styles, such as large-cap, mid-cap, small-cap and international stocks, as well as keeping a timeline-appropriate percentage in bonds. Those nearing retirement might consider adding a fund with income-producing securities.
But investors should beware of overlap. Investors often think they’re diversified because they own a few different mutual funds, but if they take a closer look, they realize those funds are all invested in the same or similar stocks.
If those companies or sectors struggle, investors could lose a big chunk of their money. Investors could avoid overlap by simply looking at a fund’s prospectus online.
To further diversify, investors also may want to think beyond stocks and bonds. Exchange-traded funds, cryptocurrency, commodities and real estate investment trusts (REITs) are just a few of the possibilities.
Investors could also diversify the way they invest. Long gone are the days when everyone turned to a stockbroker or a financial advisor to grow their money.
An investor might have a 401(k) through work but also open a traditional IRA or Roth IRA through an online financial company.
2. Lowering portfolio volatility
One of the easiest ways to help reduce the volatility in a portfolio is to keep some percentage allocated to cash and cash equivalents.
This may keep an investor from having to sell other assets in times of need (which could result in a loss if the market is down).
The appropriate amount of cash to hold may vary depending on an investor’s timeline and goals. If too much money is kept in cash for the long-haul, it might not earn enough to keep up with inflation.
There are other options, however, including:
The goal of rebalancing is to lower the risk of severe loss by keeping a portfolio well-diversified. Over time, different assets have different returns or losses based on the movements of the market. Rebalancing helps get things back to the mix the investor wants based on personal risk tolerance.
Rebalancing can often feel counterintuitive because it can mean letting go of investments that have appreciated in value (the ones that have been fun to watch) and buying investments that are declining in value.
Forgetful investors may even be able to sign up for automatic rebalancing. Without rebalancing, a portfolio’s mix may become stock heavy or sector heavy, which may significantly increase risk.
Unless investors are regularly rebalancing their portfolio (or are having it done automatically), their mix may be skewing more toward stocks than they think. Those who are concerned about market volatility might want to rebuild the bond side of their portfolio.
Bonds might not be considered the safe haven they once were, but bonds with a lower duration can still play a defensive role in a diversified portfolio. And bonds often can be used to produce a steady stream of income that can be reinvested or used for living expenses.
Municipal bonds can generate tax-free income. Bonds, bond ETFs and treasuries can all serve a purpose when the market is going down.
The beta of a stock is a measure of the interrelationship between the stock and the stock market. A beta of one, for example, means the stock will react in tandem with the S&P 500. If the beta is below one, the stock is less volatile than the overall market.
A beta above one indicates the stock will have a more marked reaction. So replacing high beta stocks with lower beta names could help take some of the menace out of market fluctuations.
3. Investing consistently
For those looking for quick returns, picking the “right” stock and selling it at the “right” time is everything. Using a dollar-cost averaging strategy is different. It’s all about patience, discipline, and looking at the long term — and it can help investors keep emotions out of the process.
With dollar-cost averaging, investors contribute the same amount at regular intervals (usually once or twice a month) to an investment account. When the market is down, the money buys more shares. When the market is up, it buys fewer.
But because markets generally rise over time, investors who can keep their hands off the stash might build a pretty nice pot of money over the long term — especially compared to what they might get from a savings account or money market account.
Some investors hand over their cash every month and don’t pay much attention to where their 401(k) plan administrator or the bank with their IRA might put it. But carefully choosing the companies represented in a portfolio — focusing on those with sustained growth over time — could help make this strategy even stronger.
4. Getting an investment risk analysis
For years, financial professionals have mostly labeled investors’ risk tolerance as “aggressive,” “moderate,” or “conservative.”
Pretty self-explanatory. But it also can be pretty subjective. The term “moderate,” for example, might mean one thing to a young investor and another to an aging financial professional.
An investor might not even know how they’ll react to a market slump until it happens. Or a person might feel aggressive after inheriting some money but conservative after paying a big medical bill.
To help with clarity, many in the financial industry are now using software programs that can help pinpoint an investor’s attitude about risk, based on a series of questions.
They can also better determine how an investor’s current portfolio matches up to a particular “risk score.”
And they can analyze and stress test the portfolio to show just how the client’s investments might do in a downturn similar to the ones in 2000 or 2008.
Identifying an investor’s current position and goals might make it easier to create a more effective plan for the future. This could involve identifying the proper mix of assets and realigning existing assets to relieve any pressure points in the portfolio.
5. Requiring a margin of safety
“Buy low, sell high!” is a popular mantra in the financial industry, but actually making the concept work can be tricky. Who decides what’s high and what’s low?
Value investors implement their own margin of safety by deciding that they’ll only purchase a stock if its prevailing market price is significantly below what they believe is its intrinsic value.
For example, an investor who uses a 20% margin of safety would be drawn to a stock with an estimated intrinsic value of $100 a share but a price of $80 or less per share.
The greater the margin of safety, the higher the potential for solid returns and the lower the downside risk.
Because risk is subjective, every investor’s margin of safety might be different — maybe 20% or 30% or even 40%. It depends on what that person is comfortable with.
Determining intrinsic value can take some research. A stock’s price-to-earnings ratio (P/E) is a good place to start. Investors can find that number by dividing a company’s share price by its net income, then compare the result to the P/E ratio posted by other companies in the same industry.
The lower the number is in comparison with the competition, the “cheaper” the stock is.
The higher the number, the more “expensive” it is.
6. Establishing a maximum loss plan
A maximum loss plan is a method investors can use to cautiously manage their asset allocation. It’s designed to keep investors from making bad decisions based on their anxiety about movements in the market.
It gives investors some control over “maximum drawdown,” a measurement of decline from an asset’s peak value to its lowest point over a period of time, and it can be used to evaluate portfolio risk.
This strategy calculates a personal maximum loss limit and uses that percentage to determine appropriate asset allocation, but that asset allocation won’t necessarily be a good fit for someone else. It isn’t a one-size-fits-all plan.
Here are the basic steps:
1. Based on historic market numbers, the investor chooses an assumed probable maximum loss for equities in the stock market. For example, since 1926, there have been only three calendar years in which the S&P 500’s total return was worse than -30%. The worst year ever was 1931, at -44.20%. So the investor might choose 40% as a probable maximum loss number, or maybe 35% or 30%.
2. Next, based on personal feelings about market losses, the investor chooses the maximum amount they are willing to lose in the coming year. Again, it’s up to the individual to determine this number. It could be 20% or 30%, or somewhere in between.
3. Finally, the investor divides that personal portfolio maximum loss number by the assumed probable maximum loss number (for example, .20 divided by .35 = .57 or 57%).
In this example, the investor’s target equity asset allocation would be 57% when market valuations are average (or fair value).
The investor might raise or lower the numbers — and be more aggressive or conservative — depending on what’s happening in the market.
The best offense Is a great defense
Whatever strategy an investor chooses, risk management is critical to keeping hard-earned savings safer and losses to a minimum.
Remember: As losses get larger, the return that’s necessary just to get back to where you were, also increases. It takes an 11% gain to recover from a 10% loss. But it takes a 100% gain to recover from a 50% loss.
That makes playing defense every bit as important as playing offense.
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