Investing involves risk. You know this already, and if not, it’s on all of our disclosures! The truth is, almost everything we do involves risk to some extent. Most of us have become good at managing these daily risks by doing simple things like wearing a seatbelt, applying sunscreen, or holding a handrail. Similar to managing our daily risks, there are some basic principles we can apply to managing investment risk. These might not eliminate the risk (wearing a seatbelt doesn’t prevent accidents), but they can help to protect us when the inevitable market volatility does happen. Keep reading to discover some of the everyday steps we can take to help mitigate risk in a portfolio.
The first step in managing risk is to identify your tolerance for it, and what things you most want to protect against. For example, a retiree taking income may want to protect against longevity risk (the potential of outliving one’s savings) and market loss, whereas a younger investor in the accumulation stage may be more concerned about overconcentration (having too many eggs in one basket) and tax risk. Once we have a better understanding of goals, time horizon, and risk tolerance, we can then start to build a strategy specific to each investor.
Risk Management
Risk mitigation tends to fall into two general categories – risk management or risk transfer. Risk management will often include tactics such as diversification, investment selection, asset allocation, or active management. When we build portfolios here at LIS, we use all of these strategies in an effort to build a solid risk-adjusted return (getting the best “bang for our buck”). In other words, we know that in order to generate incrementally higher returns, we also need to take incrementally more risk. However, we want that risk to be as efficient as possible, so that each unit of additional risk will generate the maximum amount of potential return. While these risk mitigation tools don’t provide guarantees, we believe they can provide an efficient risk-adjusted return.
Risk Transfer
The second general category of risk reduction can provide guarantees through the transfer of risk. This is the same concept that we use when we purchase something like home insurance. In those instances, we are transferring the risk of property loss or damage to an insurance company in exchange for a premium. We have similar options in the investment world where we can transfer risk. This could be the risk of principal loss, longevity risk (as noted above), volatility, nursing home expenses, etc. Like protecting property, this comes at a cost, but the way the cost is applied can vary. It could be in the form of a fee, or it might be a cap on earnings or a limit on liquidity. While none of these are inherently right or wrong, we want to make sure that the type of risk mitigation you use is a good fit for you as an investor.
Whatever your investment stage or risk tolerance, we want to make sure you are taking appropriate steps to manage your risk well. Along with that, it is important to know that investment stages and risk tolerance change over time. If you aren’t sure how risk is being managed in your portfolio, or you think your risk tolerance has changed, we invite you to get in touch with us for a review this summer. Much like putting on sunscreen at the beach, it can be a good idea to reapply!