Risk is not unique to the investment world but something that we contend with in our everyday lives. Risk cannot be completely eliminated and should not always be minimized. Individuals need to determine what is an acceptable level of risk and manage investments within the constraints of risk versus return.
The safest approach is normally considered to be an investment in either an insured savings or money market account, or U.S. Treasuries bills. While that approach will minimize volatility, it has not been protecting purchasing power in recent years. With inflation running about 2% to 3% per year and short-term investments earning essentially 0%, investors are seeing the true value of their portfolios being eroded by inflation. Someone saving for retirement will likely not achieve their long-term objectives by being too conservative.
Conversely, if an investor puts all their money in their company stock or business, they are taking excessive risk. While it is true that people have become wealthy from their company stock or business, many others have seen significant portions of their life savings wiped out by that strategy. Even large, well-established companies can see dramatic declines in their stock prices, as Bank of America and Citigroup have dropped 90% over the last several years. An investment portfolio that is primarily company stock magnifies risk, as a poorly performing company jeopardizes someone’s job along with their investments.
A good example might be someone who works in real estate. While that person may be a better investor in real estate versus someone not in the business, if the real estate market turns down, that person’s job will suffer along with their investments. That is why investors should devote a portion of their investment portfolio outside the industry they are working in. The only exception might be for someone who is young and starting a business, who might have to devote all their resources to developing the company. However, at some point, the business should become profitable enough for the owner to start investing outside the firm.
When investing in the stock market, it is important to be diversified across different industries. Someone could have a portfolio of 40 stocks, but if they are all banks, that is a riskier portfolio than someone invested in only 20 companies across different industries. Also, having a portion invested internationally helps to reduce risk, although in the short run, world markets tend to move in the same direction.
During the past decade, stocks and high-quality bonds have normally moved in opposite directions, so owning stocks and bonds lowers risk. The one exception would be high-yield or “junk bonds,” which tend to perform in a similar fashion to stocks. Therefore, while having some junk bonds in a portfolio is reasonable, someone shouldn’t own just stocks and junk bonds.
While the market gyrations this year were clearly testing people’s patience, risk cannot be eliminated. Rather, it is important to be well-diversified and for the long-term investor to have a significant portion of assets that offer the potential to grow faster than the rate of inflation.