Safety was the watchword during the 2008 financial crisis. Many investors, seeking to protect their principal, found sanctuary from the market turmoil in low-risk investments, such as money markets, certificates of deposit (CDs), and certain types of bonds. For some, the retreat was temporary. Others have lingered, determined perhaps to avoid market risk. However, they have instead taken on another type of risk – the risk their portfolios will not generate the results they need to reach their financial goals.
Every investment carries some degree of risk. Among the different categories of risk, the most recognizable is market risk, or the possibility that the market will fluctuate and you’ll lose money. But market risk isn’t all bad. Market events can also cause your investments to increase in value.
Low-risk investments have less potential than stocks. For instance, U.S. government bonds may tend to be less volatile than stocks, but they do not generally appreciate as much in value, especially over the long term.
What’s more, though low-risk investments have a place in an overall portfolio, they can expose you to inflation risk. For example, if inflation is 3% and your return is 3%, your “real,” or inflation-adjusted return, is 0%.
So how do you manage investment risks like these, protect your nest egg, and make sure your money is working as hard as possible? Here are some time-tested techniques:
Create a long-term investment plan. What are you saving for and how much will you need to reach your financial goals? Determine how much money you’ll need to supplement income from pensions and Social Security, and then adjust that amount for the impact of inflation. Your investing time horizon may also affect how much risk you are willing to take. If retirement is 30 years in the future, you may be willing to assume more risk and hope that the market gives you a chance to recover from any losses over that time. However, as retirement approaches, you might want to shift some of your portfolio into lower-risk investments. A long-term investment plan can help you find the right balance between potential risk and reward.
Embrace diversification and asset allocation. In the wake of the financial crisis, diversification and asset allocation were called into question. According to The Wall Street Journal: “The conviction shared by most investors – that they should spread their money across myriad asset classes to minimize losses – was shaken as nearly all markets tumbled in unison.”1 Yet over the long term, diversification and asset allocation appear to help investors manage risk and weather market turmoil.
Consider a 10-year period ending December 31, 2009, which includes the 2008 financial crisis and the market selloff after the bursting of the Internet bubble. During that time, large cap stocks (as represented by the S&P 500 Index) declined about -9% while bonds (as represented by the Barclays Capital Aggregate Bond Index) appreciated approximately +85%. The MSCI EAFE stocks, which measures the performance of developed markets stocks outside of the U.S. and Canada, increased by about +12%. Compared to investors who only invested in U.S. stocks during that 10-year period, investors who were diversified across all three asset classes had a better chance of owning what was doing well at a given point in time.
To manage risk, diversify your portfolio. If you put all your money into a single stock, you could lose your entire investment if the stock price falls to zero. But diversification – which is all about variety – can help mitigate that risk. When a portfolio is diversified, it is invested not in a handful of securities but in a variety of different securities and asset classes. A well-diversified portfolio offers a measure of stability because it is less likely to swing up and down in tandem with a few individual securities.
Spread the risk by creating an asset allocation strategy. Diversification works best when your investments have “low correlations” between different investment types – investments that do not tend to move in the same direction at the same time. This is asset allocation, a strategy through which you distribute your portfolio among diverse investments and asset classes. If one type of investment drops in value, that decline could be offset by gains in another type of investment. Some financial experts believe the asset allocation decision is the most important decision you can make with your investments. There are many asset classes from which to choose, including but not limited to U.S. stocks and bonds, emerging market equities, real estate investment trusts (REITs), foreign exchange and precious metals. What mix of asset classes is right for you? Your financial advisor can help you find out — and then suggest an asset mix based on your answers to questions about your personal circumstances, investment time horizon and outlook for market volatility.
Rebalance annually. As the financial markets fluctuate, the asset classes in which you’ve invested can be thrown “out of balance.” To return to the risk/reward balance you originally chose, you may need increase or reduce (that is, buy or sell) certain asset classes in your portfolio. A good rule of thumb: rebalance your portfolio at least once a year. Although rebalancing does not protect against losses or guarantee that your investment objectives will be met, it can help keep your portfolio on track toward your long-term goals.
Don’t abandon your long-term plan. A long-term investment plan can help you take the emotion out of investing. When market conditions change, you might be tempted to anticipate the market’s direction (either up or down), thinking you can make accurate decisions on when to get out and when to get in. Few people, including most experts, get that right all the time. Retreating from your long-term plan is a form of “market timing,” and market timing is the antithesis of maintaining a long-term planning perspective.
Enhance the benefits of compounding with an IRA or defined contribution plan. When you invest in an IRA or a defined contribution plan such as a 403(b), your contributions and earnings compound over time while growing tax deferred (in the case of a Roth IRA, your withdrawals may be completely federal tax free, provided they meet certain criteria). Since tax-deferred savings can help your money compound at an even faster rate than money in non-tax-advantaged investment vehicles, most experts recommend that people maximize their contributions. With more money invested, you stand a better chance of growing your nest egg quickly and efficiently.
When you’re ready to reevaluate your risk exposure, talk to your financial advisor or investment planner. They can help you determine your risk tolerance, ensure your portfolio is properly diversified, and assist you with an appropriate asset allocation strategy that is based on your investment time horizon.
Your portfolio is an important part of your savings plan. You owe it to yourself to make sure it is working hard on your behalf.
1 “Failure of a Failsafe Strategy Sends Investors Scrambling,” by Tom Lauricella, The Wall Street Journal, July 10, 2009.
The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.
Past performance does not guarantee future results. Diversification and asset allocation are techniques to help reduce risk. However, there is no guarantee that diversification or asset allocation will reduce risk or increase returns.
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