As the economy recovers from the Great Recession, investors have shifted their attention from a multi-decade preoccupation with returns to risk management. No longer able to bank on an up market and rising home values, risk has taken center stage. The truth is, of course, as you’ve heard me say many times, it is managing the relationship between risk and return that is most crucial to long-term investment success.
As the market transitions, it is especially important to keep the dynamic between risk and return in mind. With record unemployment, tight credit, and the looming threats of inflation and rising interest rates, investors are prone to worry—and that pessimism often prompts emotional decisions that ratchet up portfolio risk. In particular, today’s investors need to guard against four major risks:
Market timing. Plenty of investors have cash on sidelines and are waiting for the “ideal” time to get back into the market. However, the relatively efficient nature of the markets, combined with trading costs and taxes always stack the deck heavily against day traders. What’s more, study after study proves that missing just a few of the market’s best performing days can have negative consequences for your portfolio over the long term.
Not diversifying. As markets rebound, investors often identify a “safe” investment and over-weight it. However, over-concentrating in an asset class or sector can actually increase total portfolio risk. Diversification among dissimilar asset classes is the only academically proven risk control measure that also has potential to enhance returns. In all markets, a diversified portfolio, low-cost investments, and periodic reviews to rebalance to your original asset allocation give you the best opportunity to succeed.
Becoming too conservative. Many investors participated in the flight to safety during the recession and remain invested heavily in bonds. However, exposure to stocks is crucial to protecting your purchasing power, especially if inflation strikes. Keep in mind that while rising inflation can hurt corporate profits in the short- term, because companies can increase costs for consumers, inflation often has a neutral effect on stocks. In fact, historically corporate profits have outpaced inflation.
Reaching for yield. In today’s historically low interest rate environment, the higher yields of junk bonds can tempt investors. In fact, as the yields on Treasuries have declined, junk bond issuance has surged. Remember that bonds are loans and the credit quality of the issuer matters. Higher yields compensate you for accepting more risk, so don’t over-reach.
Although these risks may be emotionally appealing, they are economically unrewarding. Further, not only are investors not compensated for taking these risks, but their portfolios can actually be significantly penalized. Think of these risks as trying to swim upstream; you can be temporarily successful, but eventually the force of the current will overwhelm you and convince you to change direction.
Because risk is always part of the investment equation, the key to successful portfolio management is earning returns intelligently by eschewing these “bad risks” and the exposing a portfolio to “good risks.” Just as the fundamental force of gravity makes swimming downstream much more productive than fighting the current, various strategies and tools enable us to perform common sense checks on an investment’s return prospects. For example, in the equity market, the cost of capital, the rate of return a company must offer to investors to convince them to supply it with money to fund its business, helps us discern between good and bad risk/reward opportunities.
Adhering to academically based investment disciplines helps avoid emotional investment decisions, enabling us to navigate the capital markets more safely and with a better ability to control risk. You, too, can help manage risk by using these strategies to keep your emotions in check:
Stay involved. Behavioral finance teaches us that the more complex the problem, the more likely we are to choose the default option, or, in the worst case, check out and do nothing. However, refusing to confront the challenges of today’s transitioning market is a decision that could result in significant missed opportunities. In the wake of prolonged volatility and increased risk, you need to stay engaged in managing your money.
Lengthen your time horizon. To avoid making portfolio moves in response to a market drop or newspaper headline, lengthen your perspective by reviewing your long-term goals. Consider how a hasty, emotional decision you make today might negatively impact you and your family over a ten-, 20-, or 30-year time horizon.
Openly reassess. Periodically, re-evaluate your investment objectives, and understand how they relate to your risk tolerance and your investment timeline.
While it’s useless to worry about the market because it’s beyond our control, it is empowering and productive to invest and measure your success based on a time tested investment discipline. Adhering to your investment plan—and focusing on the many things that are right with your life—can make inevitable market swings easier to tolerate. In all markets, the steady hand of a trusted financial advisor who puts your needs first can help you overcome any emotional biases, think positively, and make the rational investment decisions that are essential to mitigating risk and meeting your financial goals.