By Gary Cassell,
What do you think of when you hear the word “risk”? For most of us, our basic definition is something along the lines of “the chance of losing something.” In financial terms, risk is defined as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of your original investment. (1)
If I could only teach one financial lesson, it would be teaching people about understanding risk—it is that important. In a year where we have experienced the first major downturn in over a decade, my hope is that you will have a true and realistic understanding of financial risk and the methods for managing the risk you incur by the end of this article.
There are many different types of risk, and market volatility is one of them. Due to the past decade, people seem to think the market will always go up without any downside. However, had you invested in 2000 through 2009, you would probably have a completely different mindset and expectation of how the market would perform.
In recent years, returns on investments have been incredible, which makes investors think another recession won’t happen again. But in reality, there is always that chance and people need to understand the impact of those downturns on their portfolios. Consider this: if your portfolio is down 20%, it would take a 25% return to get back to where you were before; if your portfolio is down 40%, it would take a 67% return to get back to break even. It takes a larger return than most people realize to recoup your investments. It’s important to not only understand risk and your tolerance for risk but to also implement methods for managing risk. Let’s go through 3 of those now.
One simple method for managing risk is for investors to spread out their money in different asset classes. For example, instead of risking all your money on single stocks, you spread out those funds between different asset classes, like bonds, stocks, and real estate. Having your money distributed in this way minimizes risk because they vary in volatility and external factors. The types of asset classes you feel comfortable having will depend on your time horizon and risk tolerance, so it is best to talk with a trusted advisor who can help you navigate the best options for your financial situation.
The way you accomplish dollar-cost averaging is by investing consistently. This strategy aims to avoid making the mistake of making one lump-sum investment that is poorly timed to the asset pricing. (2)
A common example is when people set a certain percentage of their paycheck to be directly invested in mutual funds or index funds offered through their 401(k) retirement plan at work. Since you are investing consistently and regularly every month, over time you are automatically buying those funds at an average price every time part of your paycheck is invested in that retirement account.
The opposite of dollar-cost averaging would be to try to time the market when you think stocks are really low, invest a large sum of money at one time, and not making any other consistent investments for the year.
Think of this method as doing maintenance on your car. In order to keep it running the way it should with the best results, you need to do work on the car to maintain its condition.
Remember the first method of asset allocation? Rebalancing is maintaining percentages of those asset allocations in your portfolio through highs and lows of the market. For example, let’s say you want to have 70% of your investments in high-risk asset classes and 30% in low-risk but lower-return asset classes. When market prices go up for your high-risk investments, the percentage of your portfolio is closer to 80% high risk and 20% low risk. To rebalance your portfolio, you would sell a portion of those investments at a premium and reinvest that money into a lower-risk asset class to reach your desired ratio of 70/30.
Are You Minimizing Your Risk?
These are just a few ways you can minimize risk, but we at Premier Wealth Advisory Services also offer advanced techniques for risk management, some of which are based on the research of Harry Markowitz, Nobel Memorial Prize winner in Economic Sciences.
If you aren’t already a client, I’d love to hear your story and share how I can help. If you already have a plan and want to make sure that it’s still right for you or if you are ready to start taking control of your financial life, I encourage you to reach out to us by calling (636) 532-7337 or scheduling a consultation using our online calendar.
Gary Cassell is president of Premier Wealth Advisory Services, an independent, fee-only wealth management firm. With over 25 years of experience in the financial industry, Gary is passionate about helping families, business owners, and executives live their lives by design, not by default, through personalized wealth management and unparalleled service. Gary earned a bachelor’s degree in physics from Hastings College and is a long-time resident of St. Louis, where he lives with his beautiful wife and two wonderful children. When he’s not working, you can find Gary spending time with his family, hiking, playing tennis, walking, and brewing beer. To learn more about Gary, connect with him on LinkedIn.