Risk is an inherent part of any investment whether it’s made by you or your business. Since there is always the possibility an investment will decline in value, investors must identify the risks, then develop a plan to minimize their effects on their overall portfolio.
Asset allocation—the practice of diversifying your money across different investment classes—is a critical decision. Not only does it help you become wealthy, it helps you keep your money by reducing risk. The allocations are made by dedicating your money between classes like stocks, bonds, commodities and real estate based on your time frame, needs and risk tolerance.
This is critically important, as one expert predicted that no matter what investment you pick, any investment will fall in price by 50 to 70% during your lifetime. The last two recessions in the 1990s, for instance, each caused a 50% stock market decline.
Since behavioral finance has found that most people fear losses more than gains, investors should divide their investments into those that are more secure, or which potentially deliver growth accompanied by higher risk. This includes stocks and bonds, but—surprisingly—not real estate. That’s because home prices overall (adjusted for inflation) have not increased for about 100 years, except in times of market bubbles. The caveat is that homes deliver tax advantages and potentially rental income.
Asset allocation should be considered a risk-growth proposition. This is because no asset class appreciates continuously. Since markets run in cycles, it’s possible to lose all gains without adjusting the portfolio. Asset allocation is done by investing in the seven main asset classes: stocks (including ETFs), high yield bonds, real estate, commodities, currencies, collectibles and structured notes.
Assets are also allocated across markets and in different time frames. This allocation can be further broken down into different styles or types of equities and bonds.
Many experts, such as Vanguard Funds’ founder, John Bogle, say the easiest way to get diversification is by investing in low-cost index funds, which provide a tax advantage as well as broad equity exposure.
Modern Portfolio Theory and Risk
Contemporary risk management has its origins in Modern Portfolio Theory (MPT). This theory traces its roots to a paper written in 1952 by Harry Markowitz, who used statistical techniques to describe the concept of the efficient frontier.
In his short paper, Markowitz proposed that the overall portfolio risk can be identified and managed by examining the risk relationships between combinations of investments. By looking at these relationships, risk could be spread—or diversified—throughout the entire portfolio. These risk-return relationships came to be viewed on a scale known as the Efficient Frontier, which showed portfolio allocations maximized along a scale of risk and return.
This was a landmark concept. By the early 1960s, Markowitz’s ideas were largely credited as being the basis for MPT. An essential part of this theory is that risk can be managed through diversification, and that better risk-adjusted performing portfolios can be built using combinations of different assets.
One landmark study found that asset allocation policy is so important that it is responsible for determining more than 90% of a portfolio’s performance variability over time.
Risk Management in the Real World
So in practice, how important is risk management? In real-world terms, the S&P 500 Index lost a total of 134% from 1973 to 2013. Alternately, the Barclays Aggregate Bond index suffered losses of just 6% during the same period. In this time frame, equities accounted for 95% of the losses. This gives a whole new meaning to the practice of balancing a portfolio, especially if investors want to limit their risk exposures.
But the investment world is constantly changing. As a result, one of the old unquestioned assumptions was that asset classes moved in different directions in different market conditions. But that idea changed dramatically during the 2008 recession when all asset classes fell together. These declines, however, are offset because researchers have found that all asset classes will have periods when they are clearly more profitable than another.
The price drivers behind all asset classes are the following: inflation, deflation and declines or gains in economic growth. Ray Dalio, an expert investor and president of the successful hedge fund Bridgewater Associates, recommends portfolio asset allocations of 30% stocks, 15% intermediate bonds, 40% long-term bonds, 7.5% gold and 7.5% commodities. This portfolio is then rebalanced at least annually.
The Importance of Timing
The timing of losses in a portfolio is another never discussed element that affects returns.
For example, if a person suffers major losses early in their investing career or when they start to retire, it can produce losses over time that cannot be recovered. In one example, a man who retires at 65 with a $500,000 portfolio and plans to withdraw 5% annually, suffers consecutive annual losses of 10%, 13% and 23% over a three-year period. During his first three years of retirement these losses will have a serious impact. These losses mean he will only be able to withdraw $580,963 from his original $500,000 portfolio.
Alternately, a woman with a $500,000 portfolio who plans to withdraw 5% annually and does not suffer any portfolio losses until she is at age 71 will be able to withdraw $911,482, or 59% more than the man who suffered losses early in his withdrawal period. The lesson is that not only is risk management important, but the timing of those losses in an individual’s savings career also has a major impact on how much they will be able to have when they retire.
Implementing a Diversification Plan
Portfolio diversification is achieved in two ways: within an asset class (e.g. bonds, stocks) and between asset classes. Risk—or the variability of achieving a specific investment return—relies on a variety of factors, such as those related to a specific investment, as well as the overall economy.
Economic risk comes from factors like news about inflation, industrial production, employment, monetary policy, consumer sentiment and international events.
All of these factors influence the stock and bond markets in different ways. By diversifying across asset classes, you can reduce investment risks that will affect the variability of returns. Investors who diversify but limit themselves to a single type of asset class (e.g. small-cap stocks) assume more risk than those who invest across different types of asset classes.
Thanks to MPT, there are a number of different mutual funds today that can deliver a diversified portfolio of investments in a single fund.
While Markowitz’s idea is over 50 years old, his theory of linking risk to return has helped create an entire industry devoted to risk management. For investors, this has made it possible to quantify a portfolio’s risk level, so investors should expect to get a higher return if they assume more risk. That simple idea has reshaped investing.
For more investment advice from financial expert Chuck Epstein, read his article on retirement accounts and minimum distributions.