We’ve all heard the term, “no risk, no reward” right? Well, that can be true but not necessarily. I’ve seen countless portfolios with high levels of risks with absolutely no chance for a positive return that correlates with the level of risk taken.
Taking risk for risk’s sake is not an investment strategy! Tweet That Risk is always involved in establishing and managing a successful portfolio but the real goal is to implement your investment goals in a manner consistent with what I refer to as your “risk tolerance.”
Different Investments-Different Returns
There are three general basic asset classes available to invest in when it comes to the stock market: (1) stocks, (2) bonds, and (3) cash or cash equivalents.
Historically, stocks have given the greatest returns. But in order to get those greater returns, you have to be willing to assume greater risk.
Three Kinds of Risk
Every investment strategy (even the “safest” ones) carry risk.There are really three distinct types of investment risk you should be aware of when you are considering your investment objectives and the affect on each of the three asset classes: stocks, bonds
The first and the most commonly thought about risk is Capital Risk. This is the chance of actually losing principal, or capital. And, in my experience it’s probably the biggest fear for most investors.
All but the most conservative investments experience some sort of fluctuations. Over very short periods of time (like months or even a year), volatile investments will sometimes suffer a loss. But when longer time periods are considered (like 5, 10, or even 20 years) these fluctuations are likely to smooth out into eventual gains.
This is why it is so important that you invest for the long-haul. Investing in the stock market is not a short-term game. This risk-Capital Risk-is reduced substantially as your time horizon lengthens.
Even with stocks, where the risk of capital loss is much higher than for other asset classes, it is rare to have 5, 10, or 20 year periods with losses.
But, investments with short-term time horizons do not stack up so well.
The second type of risk I want to address is Inflationary Risk. And it can seriously erode your wealth. In fact, I call this the silent tax because it’s very difficult to see the impact of it on your portfolio.
I talk with many investors who want to keep their money “safe” because they don’t want to lose it. But if you keep it too “safe”, and therefore don’t get the corresponding rates of return to go with it, you will lose money. And this loss comes in the form of lost purchasing power.
Purchasing power basically indicates how much in goods and services your dollars can buy, and when it is eroded by inflation, the value of your investment diminishes.
Here’s an example: If there is an average of 4% inflation per year, an investment portfolio worth $500,000 today would be worth less than $330,000 from a purchasing power standpoint at the end of a 10-year period.
This is the same reason that, if you don’t have increasing income, you’re actually losing income each and every year. You know as well as I do that a gallon milk or a gallon of gas is going to cost more tomorrow than it does today.
So, as inflation cuts into the purchasing power of an account, the investment has to not only grow but to grow faster than the rate of inflation by a significant margin.
Again, this is why investing is so, so important! You have to compete with inflation.
The third type of risk is liquidity risk. Liquidity risk refers to the ability to get your money when it is needed.
For example, a portfolio higher volatility will make it more difficult for you to meet your specific funding needs at specific times. You have to consider your time horizon and withdrawal needs.
Are you going to be needing money in the near future for a home purchase? Children’s education? Or will you need it in the next 20 years or 30 years for retirement?
If you have immediate needs from your portfolio, you risks selling assets when they are low. If you need access to funds in your portfolio within a relatively short period of time or if will be taking regular withdrawals from your portfolio in retirement, you may want to consider a less risky portfolio consisting more of Short-Term Fixed Income instruments and less of volatile equity assets.
The opposite of course is true too. If you won’t need money for any length of time, liquidity risk should not be as big of a concern.
Risk and Reward
Most people inherently know that higher risk should equal higher return but that’s not always the case.
If you’re going to assume greater volatility you should also demand greater rewards and the prospect of a higher long-term rate of investment. Stocks, historically, have subjected investors to the greatest capital risk but they have yielded the greatest returns.
Treasury bills, or cash, show the lowest chance of capital loss and the lowest returns.
Your job as an investor, if you want to be successful, is to choose between the level of risk you’re willing to accept and the level of return likely to be received.
If you’re not willing to take the time to do that, don’t invest in the market or work with an investment advisor who can help you with the balancing act of risk versus reward. If you don’t have anyone and want to have a discussion with me about it, head to www.cittica.com/contact-us and we can talk about your options.
One of your primary jobs, or that of your financial advisor, is to allocate investments among the different asset classes to manage your risk. Your job should be to get the highest return available for the lowest amount of risk possible.
This balancing act depends to a great extent effective asset allocation.
You’ll also want to evaluate your:
- Time Horizon-This is the period of time available before you’ll need access to those funds. This is an important factor in determining the level of risk you can reasonably assume.
- Risk Tolerance-Every investor has a different level of tolerance for risk. How much are you willing to lose in your portfolio in order to realize a potential gain? It is important to know the answer to this question because when things go bad (and they will at some point) you have to be willing to stay invested.
- Investment Objectives-Is your goal to aggressively grow your portfolio? Is your goal to preserve what you’ve already built? This will allow you to choose your investment allocation.
Here are four very general asset allocations so that you’ll have an idea of how you should be investing. This is not an exhaustive list but it will give some guidelines. Again you’ll have to do this on your own or hire an advisor.
1. Income and Growth (25% Equities / 75% Fixed Income)
The idea of an income and growth portfolio is to minimize volatility and still try to earn a rate of return that will stay ahead of the consumer price index (C.P.I.). This approach provides the least amount of volatility of the allocations that I’ll go through but the possibility of negative returns is not eliminated, only reduced.
Keep in mind that this approach does imply a substantial reduction of capital growth when compared to the stock market. And, that is why it’s objective fits with a time horizon of less than three years.
2. Balanced Growth (40-60% Equities / 40-60% Fixed Income)
This objective has two purposes: to preserve capital and to obtain capital growth. This objective implies that there a need for a balance between preserving your money and long-term growth.
The earnings potential of your investment in this portfolio will be less than in the some of the more aggressive portfolios that I’ll talk about but it should also be less volatile over time. This would be a portfolio that would potentially be suitable for someone with a time horizon of three to five years.
3. Long-Term Growth (75%-85% Equities / 15%-25% Fixed Income)
This portfolio has the potential to provide a reasonably high rate of growth without the full degree of risk usually found in the stock market. The primary goal is long-term capital growth while the secondary goal is preservation of capital.
Keep in mind that in order to achieve long-term capital growth, you’ll have to assume greater volatility and the risk of negative returns.
Six to nine years may be required to achieve this objective. Annual withdrawals may not be appropriate with this objective due to the short-term volatility of the stock market.
4. Aggressive Growth (95% Equities / 5% Fixed Income)
In this last portfolio the only goal in this objective is growth. You must also accept a high degree of risk inherent in the stock market. This objective provides the greatest growth potential of the seven, and exposes the Account Owner to the greatest degree of volatility.
This is designed to be a long-term investment strategy of at least ten years.
When you learn about risk and how to manage it in your own portfolio, you’ll be well-suited to weather the inevitable ups and downs of the stock market. After all, the goal of any investor should be to increase returns and/or lower your level of risk. When you do, you’ll be well on your way to financial success!