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How To Manage Investment-Allocation Risk
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Business New Haven
11/12/2001
By: Susan Cornell
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For many of us, “risk” conjures negative images - bungee jumping, placing bets on the long shot, or speeding. Mention risk in terms of investing and some might think about losing their life's savings. In reality, though, investment risk comes in a variety of flavors, and each can affect how you pursue your financial goals. The key is learning how to manage investment risk.
First: Understand the various risks involved. Barron's Finance & Investment Handbook defines risk as the “measurable possibility of losing or not gaining value.” The fear of losing money is one reason people choose conservative investments, even for long-term savings. While investment risk refers to the general risk of loss, it can be subdivided into specific types. No matter how well diversified your portfolio, there is no way to completely eliminate risk. Some investment risks to consider as well as how to reduce these risks include:
• Market risk. Also known as systemic risk, market risk is the likelihood that the value of a security will move with its overall market. This risk may be reduced by holding an investment for a long period or by investing in more than one asset class. Asset classes include stocks (large-cap, mid-cap, small-cap), bonds and money market instruments.
• Specific risk. Investing in a single security creates the risk of losing money if the issuer should run into trouble. Investing in a broadly diversified mutual fund with many securities is likely to reduce this risk.
• Inflation risk. Rising prices due to inflation can erode the purchasing power, or real value, of investments. Inflation risk needs to be considered when evaluating conservative investments such as money-market funds, bonds and bond funds as long-term investments. While your investment may post gains over time, it may lose value if it does not at least keep pace with the rate of inflation. Over long periods, stock investments have beaten inflation by a larger margin than cash or bond investments.
Manager risk. The investment manager may make sound decisions that help your investment “beat the market,” or she/he can make poor decisions. Investing in index funds that seek to match the performance of all or part of the bond or stock markets can reduce this risk, but surrenders the upside of a manager who outperforms the index of the market.
• Interest-rate risk. This refers to the fluctuation in bond prices and some common stocks due to changes in interest rates. Interest-rate risk can be mitigated by holding shorter-term bond funds.
Secondly, manage risks with diverse investments. The eggs-in-one-basket cliche is perfectly relevant to the realm of investing. Diversification, or spreading your money among several investments and investment classes, is used to mitigate a portfolio's market risk.
Third: Match your investments to your goals. Financial experts agree that your asset-allocation decisions are critical-and possibly the most important factor-in determining both the volatility of your portfolio and the long-term return. Four interrelated factors should be considered in determining asset allocation:
• Your investment objective.
• Your time horizon.
• Risk tolerance.
• Your personal financial situation.
Your personal financial situation and your ability to tolerate investment risk are the most personal elements shaping your asset mix. Risk tolerance is your willingness or ability to endure declines in the value of your investments while you wait for them to return a profit that will help you to meet your investment goals. Some investors can ride it out with an eye toward long-term goals, while others become anxious when the value of their portfolio declines by even a small percentage. Your emotional makeup plays a major role in how you allocate your investment assets.
One way to gauge how much risk you can endure is to examine downside risk, or the amount you might lose in one year. In other words, determine how bad the worst years have been and, based on your findings, you may decide to choose lower- or higher-risk allocations.
Asset allocation - how you weight investments in your portfolio - is a strategy for investment success. The risk and reward levels of the three major asset classes are:
• Stocks - Stocks carry a high level of market risk over the short term. But stocks have historically earned higher returns than other asset classes. Stocks have also historically outpaced inflation.
• Bonds - Generally, these securities have less severe short-term price fluctuations than stocks and thus offer lower market risk. However, their overall inflation risk is higher.
• Money market instruments - These are among the most stable of all asset classes and carry relatively low market risk but with no inflation protection.
When considering how to balance risk and return in your portfolio, don't forget that risks other than risk of loss exist. The risk of investing too conservatively and not reaping high enough returns to provide for your financial future is a key issue. As well, beware of investing in instruments that may be too risky for your short-term goals. A financial advisor can help you to select vehicles suitable for your goals.
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