Risk is something we live with every day. There are risks in the every day activities like driving a car and trying a new restaurant or recipe, or starting a business or accepting a new job. Most situations and endeavors come with their own risks and rewards.
Similarly, investing is all about risks and returns. As many investors have learned the hard way, an investment offering unusually high returns, such as rapid growth or rich dividends, comes with higher risks. Conversely, if you find an investment with almost no risk, its return is likely to be very low.
Risk can be your friend, or foe, in accomplishing long-term financial goals through an investment plan. You can make the difference by knowing your own feelings about risk, understanding how to evaluate it and learning to manage risk over the long haul. Investing is not about risk elimination, but more about prudent risk management.
Risk management: Know yourself.
Financial professionals see a very close relationship between risk and returns: Higher-risk investments (stocks, long-term bonds) must yield higher returns over the long run to attract investors, while lower-risk investments (bank accounts, Treasury bills) can pay lower returns.
Recognizing that risk is built into investing is the first step in knowing your own capacity for accepting risk. As you begin forming an investment plan, or make adjustments at key points in life, it is important to understand that prices of most investments can rise and fall.
Of course, knowing intellectually that investing involves risks is not much help when a monthly statement arrives and the value of your portfolio has dropped. Avoid first impulse emotional reactions in cases like this. As long as you are progressing toward long-term goals, there’s no need to panic or abandon your long-term plan.
Exploring your risk preferences in advance is a good idea. You can assess what level of risk you are comfortable taking, working on your own or with an advisor. But go beyond the general questions of “Are you a conservative, moderate or aggressive investor?” Also ask yourself the following:
- Do your long-term goals require that you use potentially higher-return investments (with their risk level) to get from point A to point B? Or will a focus on preserving assets provide what you need?
- How soon will you need to spend the money you are investing? Does your time horizon allow ample time to recover from short-term losses in assets that fluctuate, such as stocks?
- Are you emotionally prepared to accept higher risk, some risk, or none at all?
- What is your attitude toward the market? Is it: “I never want to see the value of my funds go down” or “I can weather the impacts of the market as long as I’m on track for the future”, or something in-between?
Investors who fail to clarify their feelings about risk tend to get surprised by the market, causing them to panic and bail out of sound financial plans.
Risk management: Measure risk.
It’s a good idea to understand how to measure risk and how to assess the impact of additions or alterations in your portfolio.
Risk and volatility are closely related. Volatility refers to the likelihood of changes, up or down, in an investment’s value. High volatility means the price can change quickly and dramatically in either direction. A fund with low volatility is historically more stable, less prone to large swings.
Technically, risk also deals with up or down movements, but people tend to take a practical view of risk: We do not like to lose money, so we try to guard against downside risk. We think of risk as the chance that we will put in a dollar and not get at least a dollar back.
A common measure of volatility is “beta,” a calculation that tells you how closely a fund or security has historically tracked with fluctuations in the broader market. If beta equals 1.0, the price of the investment moves exactly in sync with a benchmark such as the Standard & Poor’s 500 index. If beta is greater than 1.0, the fund or security tends to rise (or fall) more than the market. If beta is less than 1.0, the investment does not fluctuate as much as the benchmark. Beta is useful in choosing investments that tend to be more stable or more volatile.
Another measure of risk is the Sharpe Ratio. The Sharpe Ratio analyzes whether a portfolio’s returns were a result of smart investment decisions or a result of excess risk. It also represents how well the return of an asset compensates the investor for the risk taken. For example, if you compare two assets against a common standard, the asset with a higher Sharpe Ratio will provide a better return for the same risk. This helps to distinguish a good investment from a “risky” investment if the investments with higher returns do not come with too much additional risk.
Services such as Morningstar and Value Line also measure up-versus-down behavior of funds. When the market as a whole drops, is the fund likely to decline more, or less, than the trend? And when the market rises, does the fund really soar, or enjoy a slow-but-steady increase?
Getting to know the various measures of risk helps you evaluate individual investments and, more importantly, the mix of assets that together represent your investment portfolio.
Risk management: Manage your portfolio.
Most investors need to take some risk to achieve returns that will their meet long-term goals. The best way to manage risk is through careful attention to asset allocation and getting the right mix of investments to match your stage of life, financial goals and risk tolerance.
You can assemble a portfolio that mixes different classes of stocks, bonds and cash to provide an expected level of appreciation while also limiting risks. Clearly, you want to avoid risk levels that could deliver a catastrophic setback to your plans. Make asset allocation your No. 1 investing discipline, either on your own or working with one of our investment advisors.
Monitoring your progress is important. We suggest you personally review your portfolio on a quarterly basis and meet with your financial advisor once or twice a year to review your financial plan and asset allocations. In examining your investments, don’t just look at the returns but also check for any changes in risk levels or the mix of risky and less-risky assets in your portfolio.
Additionally, if your financial position or life situation changes significantly, you’ll need to revisit the risk profile within your portfolio. An inheritance might cause you to scale back on risk, shifting your strategy from maximizing returns to preserving wealth. Starting retirement, facing a health issue or losing a spouse might cause you to reassess the proper level of risk and desired returns.
A quick way to assess your risk level is to ask how investing feels. If checking your portfolio fills you with dread because losses threaten your future — or delivers thrill-a-minute excitement as you rack up big gains — watch out! Excessive risk may have you on an emotional roller coaster. On the other hand, if your portfolio moves slowly but steadily year-after-year toward long-term financial goals, that may be the level of risk with which you’re more comfortable. Each investor is different, so it’s important to determine what feels right for you when building your investment portfolio.
What to do next
- Consider risk important when assessing returns within your investment planning.
- Make a serious evaluation of your attitudes toward risk, on your own or with an investment advisor.
- Check the risk level of each investment and your overall mix of assets.
- Build your portfolio with an appropriate balance of risk levels and expected returns.
- Review your portfolio on a quarterly basis and revisit your asset allocation and risk profile at least twice a year.