Investing and Managing Risk

Investment is really about management of assets on a great sea of risks. One hears stories of folks who have made a fortune on a daring play with a big bet on a hot stock or lost it the same way. In each case, the investor was exposed to substantial risk. That’s no way to build a retirement portfolio or a family fortune. There is risk in every action or inaction one can take. The investor’s dilemma comes down to how much money to commit to any given investment.

Diversification

There are no sure things in capital markets. The wise investor diversifies investments in order to achieve planned objectives and 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 in 30 years, more risks can be taken than if money is needed to pay for a vacation in 6 months.

Event Risk — What can go wrong with an investment? Stocks, stock funds 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.

Insurance is part of risk management

Risk management includes investments that explicitly reduce risk. Virtually all forms of insurance do this at the cost of the premiums one pays for shifting risks to the insurer. In this sense, insurance is the mirror image of investments that generate returns for accepting risk from a corporation or from a market. Insurance is not usually included in discussions of investments, but it is very much a part of risk management. Thus a person who has purchased substantial permanent life insurance that may fund a comfortable retirement can take more risks with an investment account than someone who has no insurance and who must avoid losses lest he or she be forced to retire in poverty.