Investment is Risk Management
There are no sure things in capital markets. The wise investor diversifies investments in order to achieve planned objectives and to minimize volatility along the way. Diversification requires the investor or advisor to evaluate the following issues:
- Time Risk
- When is the money needed? If the goal is to finance retirement is 30 years, more risks can be taken than if money is needed to pay for a vacation in 6 months. Time risk is specific in negotiable bonds, which may rise or fall in price but always mature at face value on a fixed date. The credit risk of insolvency exists in corporate bonds, but it tends to be acceptable in investment grade bonds with maturities of 5 to 7 years or less. The theory is that a major corporation with a solid balance sheet is not likely to become insolvent or unable to pay off its bondholders within the foreseeable future of half a decade or so. Time risk in stocks is difficult to estimate, but, unlike that of bonds that fluctuate in value until they mature at their face value, the time risk of stocks tends to diminish over time as earnings rise and push up their market price.
- Event Risk
- What can go wrong with an investment? Stocks and high yield bonds (also called junk bonds) are subject to the whims of fortune. The more money that goes into stocks or stock funds, the greater is the need to diversify and so spread event risk among many stocks. The more one diversifies, the more likely the stock portfolio is to produce returns similar to those of the classes or sector of stocks it holds and of the market as a whole. Government bonds, by contrast, tend to be immune from event risk and, in times of misfortune, they often rise in price as other investors rush for the safety they offer. Clearly, it is wise to hold some bonds for risk management.