Are you a risk taker?
If you have investments on Wall Street, you are. You might not be a skydiver, scuba diver, or venture capitalist, but you're a risk taker. Your money is at risk of loss. Investors know that the amount of money they are likely to earn on their investment is directly related to the amount of risk they are willing to accept to generate that return.
What continually amazes me, however, is how misinformed most investors have as to the amount of risk they actually have. I'd say that 75% of the folks I interview who tell me they are "very conservative" when it comes to their tolerance for risk, have no idea that their stockbroker has them heavily invested in high to moderate risk funds!
We know that we need to take some risk. What we don't seem to know is this: we should always take the least amount of risk necessary to generate a required return. In other words, if you can earn 8% a year taking a low risk, why on earth would you want to take a moderate risk to get that same 8%?
In a sane world, you wouldn't. Is your broker living in a sane world?
Let's manage our risk!
There is no such thing as zero risk for investors. There are some great strategies for managing risk, however. Here are 4 of my favorites:
- Dollar Cost Averaging
This is simply a technique used which involves buying securities on a regular basis. For example, each week when you get paid, contribute a certain amount to invest. What the market happens to be doing at the time you buy isn't a consideration. You just commit to invest on a regular schedule. Studies have shown that by investing this way you will consistently be buying low and selling high, over time. This works because risk tends to diminish over time.
Diversification means "don't put all your eggs into one basket." Find someone who had their entire portfolio in GE stock a few years ago, and they will absolutely agree with this (GE went from a high of almost $58 a share to less than $9! It has yet to recover). Diversification is the theory that you should buy "Coke" and "Pepsi", the idea being that as one goes down, the other will go up. Having a well diversified portfolio will give you a warm and fuzzy feeling in your investing heart. Until another market correction such as the one in 2008 comes along, and you learn that diversification offers no protection from an overall market correction. "Coke" and "Pepsi" will both be singing the blues.
- Stagger Fixed-Income Securities
Staggering the maturity dates of fixed income securities (such as bonds) is another way to reduce interest rate risk. This technique will allow the investor to reinvest at different times and interest rates as the old investments mature.
- Use Absolute Return Managers
In my opinion, this one is the most useful, as it will integrate nicely with the other three. Absolute return managers are more concerned with principal preservation than relative return managers, and should, over time generate higher returns. When you have to recover losses every few years it can have a very negative effect on your portfolio.
You need to know how much risk you are exposed to!
One great question to ask your broker is, "what's the greatest amount of money this fund has ever lost?" He'll be very happy to show you the 3 and 5 year results, but if those 10 year statistics should pop-up, he'll probably be less enthusiastic. But it's a crucial question. When it comes to investment risk, the subject needs to be examined closely.
Until next time,
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