To quote an episode of the sitcom “Seinfeld,” “In order to manage risk we must first understand risk.”
How do you spot risk? How do you avoid risk and what makes it so risky?”
Risk in your financial life can take on many forms. Some of them seem obvious, others lurk beneath the surface, but must still be addressed. The many forms of risk may not be avoidable, but they can be prioritized and managed. In the next several installments, we’re going to discuss some of the types of risk present in your financial life.
When many people think of risk in their investment portfolio, they usually think of market risk because it is the most apparent. Simply put, market risk is the risk that your investments will decline in value, often measured in degrees of volatility (variation from the average). Cash generally provides returns within a narrow range, bonds have a wider range, and stocks generally fluctuate the most.
Investors are often categorized by their affinity for, or aversion to, market risk across a spectrum spanning from Conservative to Moderate to Aggressive.
Investors who are more aggressive are generally considered willing to accept greater market volatility in exchange for presumably higher returns, while conservative investors are willing to accept lower returns if it spares them the ups and downs of the markets.
A properly diversified portfolio is necessary to manage market risk. Stocks and bonds (and the different variations thereof) react differently to market stimuli. While one investment may be losing value, in a properly diversified portfolio, another should be there to buoy it.
Many people think that since bonds are relatively less volatile, on the whole, than stocks, then a portfolio consisting of entirely bonds should be considered “safe.” Historically, they’re wrong.
Note on the accompanying graph that a portfolio consisting entirely of bonds has actually been subject to more overall volatility than one consisting of 60 percent stocks. This is simply because a lack of diversification in an all-bond portfolio means that, when bonds declined, there was no other asset class present to buoy the portfolio. This investor has sacrificed returns, while needlessly subjecting themselves to relatively higher volatility than a diversified investor would have incurred.
Historically, exposing even one third of the one’s portfolio to the stock market dramatically decreased the portfolio’s overall volatility, while also increasing the likelihood of long-term gains. Some stock exposure adds a much needed ballast to a conservative investor’s portfolio.
You’ll also note that, over the long-term, a stock portfolio has rewarded investors with a greater return, given the investor was willing to accept much greater market volatility.
Ultimately your exposure to market risk should take into consideration two things: how much risk you need to incur to experience the rate of return necessary to support your lifestyle, and your innate ability to accept risk (i.e., can you sleep at night).
Work with your independent financial advisor to develop a plan which assesses your need for risk, and your affinity for, or aversion to, it in order to help ensure that your portfolio is growing enough to support your lifestyle in retirement, while still weathering the ups and downs of the markets so that you can rest comfortably. Your advisor will help counsel you through periods of higher volatility and periodically reassess your exposure as your needs change.
Stephen Kyne is a Partner at Sterling Manor Financial in Saratoga Springs and Rhinebeck.
Securities offered through Cadaret, Grant & Co., Inc. Member FINRA/SIPC. Advisory services offered through Sterling Manor Financial, LLC, an SEC registered investment advisor or Cadaret Grant & Co., Inc. Sterling Manor Financial and Cadaret, Grant are separate entities.
