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4 Tips For Investors To Balance Risk And Reward

For Equity Investors, the balancing act between risk and reward manifests itself in a simple question: Should I diversify my portfolio?

For Equity Investors, the balancing act between risk and reward manifests itself in a simple question: Should I diversify my portfolio?

The answer depends on a number of factors, including your need or desire to quickly grow your wealth, your tolerance for risk and your understanding of the consequences if things don’t go as planned.
Clearly, owning a concentrated position in a single common stock can have great rewards.

Just look at Microsoft Corp. founder Bill Gates and (AMZN) founder Jeff Bezos. Gates’s net worth is upward of $100 billion and Bezos’s comes in at just shy of $140 billion. To put those numbers into perspective, their combined net worth is greater than the total gross domestic product of New Zealand. That wealth is the direct result of owning a big chunk of stock in the companies they founded.

Rewards vs. Risks

The potential reward of owning a concentrated stock position has to be balanced against the very real risk that it imposes – particularly for individual investors who are not founders of successful, publicly traded startups.

Even for billionaire shareholders, large concentrations can also be pretty tough on one’s balance sheet. In just December 2018, Gates lost $1.2 billion in the value of his Microsoft stake and Bezos suffered a decline of $21 billion in his Amazon holdings. To put those numbers into perspective, they are nearly the value of Iceland’s entire GDP.

One could argue, however, that since those guys are so rich, their concentration risk is actually immaterial. They can lose $1 billion (or $10 billion) here and there without it causing any real pain. So the follow-on argument one could make is that concentration risk isn’t really a bad thing.

That’s a message that “Rich Dad, Poor Dad” author Robert Kiyosaki, has championed for decades. He says that in order to build great wealth you should “focus … rather than practice diversification.” That may work well for people like Gates and Bezos, but for the average investor, it isn’t sound advice.

While it is probably true that losses suffered by the two billionaires in December may be inconsequential to them, proportional losses incurred by a retiree with $1 million or $2 million could have detrimental effects on his or her financial well-being.

Between Gates and Bezos, the average decline in that one month was 12.6 percent. The proportional loss to an investor with $2 million would be a staggering $252,400. That’s more than the median price of a home in the U.S. For someone using his or her investment portfolio for income, making up that more than quarter-of-a-million-dollar loss could take years. This means the rules that apply to multi-billionaires truly do not apply to the average investor.

Here is snapshot of some rules that do apply to mere mortals:

  • Create and live within a budget.
  • Develop and stick to a plan.
  • Align your portfolio with your plan.
  • Look for hidden concentration risks.

Create and Live Within a Realistic Budget

Before you start thinking of putting all your eggs in one basket, consider what that basket will ultimately be used for. If you’re like most Americans, you are planning on using your retirement savings to finance just that – your retirement. To make sure that you’ll have enough saved to do that, figure out how much you are spending right now. Then, consider that amount in the context of life in retirement when you won’t have an earned income to support your spending.

Now, this may seem obvious, but commit all of this to paper (or a spreadsheet on a computer). If your income is enough to support your lifestyle and you have a little left over to save, that’s great. If you don’t, then you need to rethink your spending habits. The reason for this is that they are not likely to change too much after you retire. In the long run, a best practice is to live a little beneath your means.

Develop and Stick to a Plan

Once you have a budget, plug it into an overall financial plan that takes into account your current pool of savings and investments. Ask a professional advisor to help you model that out into the future to estimate its value at different points in time and under different “what-if” scenarios.

If those estimated outcomes don’t align with what you expected, then change your plan; spend less or save more. When the model gets you to a place that shows that your savings and investments will sufficiently finance your retirement, then memorialize it – and stick to it!

Align Your Portfolio With Your Budget and Plan

As part of this process, make sure that the assets in your investment portfolio are properly aligned with your budget and financial plan. The composition of those assets will have a huge impact on your likely (expected) future rate of return. Different assets behave differently under different circumstances. And, each offers different expected rates of return and different types of risks. So, the mix (or allocation) of those assets will play an important role in the success or failure of your budget and financial plan. Ask an advisor for help developing your asset allocation to help you with the delicate balance of risk and reward.

Look for Hidden Concentration Risks

Finally, look for concentration risk in places that may not seem obvious. Look at the mutual funds, exchange-traded funds, and annuities you own. Make sure that there isn’t potential concentration risk in any of those vehicles. A fund with an overexposure to a given stock or business sector may impose on you undue concentration risk. We frequently see investors with a large position in a popular holding, such as Apple, in addition to funds that also hold big chunks of the same stock. Ask your advisor to provide a portfolio X-ray to determine where you may be vulnerable to concentration risk.

There is no doubt that Bill Gates and Jeff Bezos have made billions by holding a large concentration of just one stock. But, not every big stakeholder fares the same. Eddie Lampert, manager of the hedge fund ESL Investments, lost billions on his majority ownership of once-iconic retailer Sears. Robert Goldfarb, manager of the Sequoia Fund has also lost billions owing to a concentrated position of a losing investment. His was Valeant Pharmaceuticals.

While a concentrated position does have its rewards, they don’t come without a healthy serving of risk.

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