The return-centric environment in which we live too often gives little credence to an equally important measure – risk. Professionals and individual investors alike can often quote the return of a given stock or index, followed by silence when asked to recite its relative measure of risk. The financial crisis shouted to us the importance of understanding and controlling risk. If you did not hear the call – and hopefully you did before the fall – it’s not too late to answer it.
Two quantifiable means of controlling risk are diversification and asset allocation.
Proper diversification stretches well beyond your region and your country of residence. It has little to do with individual stock positions or individual sectors. It consists of all types of stocks – large, small, value, growth, etc., which are located all over the world. Global diversification is the goal.
Diversification is equally important for bond allocations. A bond portfolio consisting of high-yield bonds differs from one invested in U.S. treasury bonds. Obtaining an adequate amount of diversification on both sides of your portfolio is essential in controlling your risk.
Asset allocation speaks to the percentage of stocks and the percentage of bonds in your portfolio. While the specific mix has many variables, age and retirement goals are often large factors. Each investor’s situation is unique and there is no “one size fits all” solution. A good place to start is by answering the following questions:
- At what age do I begin adding bonds? 40? 45?
- How often do I add bonds and how much do I add?
- What is an appropriate allocation once I am retired?
If you are struggling to answer these questions, it may be time to seek professional guidance. The answers are essential to your long-term investment success.
As stocks outpace bonds, a portfolio’s risk increases. At some point, there will be a need to sell the stocks to buy bonds and maintain the target allocation. In essence, this follows the golden rule of investing – that is to sell high and buy low. The same logic holds within each asset class of the portfolio, such as when international stocks outpace domestic stocks or small cap stocks outpace large cap stocks.
I can almost guarantee that when the time comes, rebalancing will not feel like the natural thing to do. Why, for example, would you want to buy into an underperforming asset class? Despite our rational brain, loading up on the winners will feel like the right thing to do at that moment. There are two questions you must ask yourself:
- Do I have the discipline to rebalance my portfolio?
- What mechanical process will I use to rebalance?
Your long-term investment success hinges on your answers to these questions. If you do not know how to answer them, seek guidance.
Investing is about risk and return. Understanding how much risk you can afford to take and how much risk you’re willing to take is the key. Quantitatively, two ways in which we control risk for clients is through diversification and asset allocation. Keeping clients disciplined in their goals and executing on a well thought out rebalancing process is another, less tangible means of controlling risk.
As Warren Buffet famously said, “It’s only when the tide goes out that you learn who’s been swimming naked.”