Is your portfolio risky business?
Manage rather than avoid
You wear many hats…perhaps you are an employee, parent, sports enthusiast, traveler, author, creative genius. You likely are an investor as well. That part of your life, though, has a unique characteristic: unlike with many of the hats you wear, taking risks is a necessary part of the endeavor.
Understanding those risks and then managing them smartly will help you be successful—and help to instill confidence in your investments. Let’s look at how you can build a more effective portfolio by managing those risks rather than trying to avoid them.
What are the risks? Different investments come with different risks…and those risks are a fact of life. For example, stocks generally come with market risk, also known as systematic risk. Bonds come with interest rate risk and also credit risk. Even very conservative cash investments like Treasury bills come with some risk…inflation risk. But this is just a generalized picture. The balance between risk and return varies by the type of investment, the entity that issues it, the state of the economy and the cycle of the securities markets. As a general rule, to earn the higher returns, you have to take greater risk. Conversely, the least risky investments also tend to have the lowest returns.
How do I manage these risks? The goal is not to avoid all risks but to have a portfolio that reflects your comfort level with it. Your financial advisor can work with you to assess your tolerance for risk and design a portfolio that is suitable for your individual circumstances. Many people opt for a long-term time horizon and a buy and hold strategy.
First of all, remember that a portfolio that is diversified among a variety of securities can give you the potential for a higher return with the same or less risk. A portfolio made up entirely of stocks is missing out on a wealth of opportunity. Reviewing these basics on risk will help you see that you can diversify while keeping the concern over your risks in check.
Long-term investing gives your portfolio the opportunity to grow exponentially. Positive returns have the potential to compound. For example, if $10,000 were invested and your portfolio were to grow at a constant rate of 7.2 percent your portfolio would reach $20,000 in 10 years.
- Generally speaking, consider holding on to the stocks for the long term, 10 years or longer if you are able.
Interest rate risk, which occurs when rising interest rates cause a bond’s price to fall, can be managed as well. While increasing interest rates may have some impact on stocks, they directly impact your bond investments.
- So, another strategy, when short-term rates are rising, is that this might be the time to sell older bonds that pay a lower rate of interest (leading to their prices falling) and buy newly issued bonds that pay higher interest rates.
- Keep in mind that investing in bonds also comes with the risk that the bond issuer could default on interest and principal payments.
Cash investments, such as with three-month Treasury bills from the Government, can be another good component to your portfolio. Because they are backed by the U.S. Government, you might consider them trustworthy, yet they too come with some risk due to the possibility of inflation.
- Keep an eye on inflation and use your cash investments for the short-term, usually a year or less.
Your risk/return profile
The last component of successful investing related to risk is knowing yourself well. Ask yourself how much risk are you able to handle balanced against your need for a certain return on your investments.
Your financial advisor will be able to help you get a clear picture of your personal risk/return profile.