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Why Investors Need the Right Risk

It’s important to know what market risks are worth taking and which drag down returns.

Investment Chart

Wouldn’t it be great to find that magical investment that delivers high return with no risk?

Hope springs eternal, and plenty of people remain optimistic that this unicorn investment exists out there, somewhere. They just need to identify it. Of course, if such a vehicle were real, people from all corners of the world would pile in. It certainly wouldn’t be a secret.

Investing, by its very nature, is a risky endeavor. It’s because of that risk, not in spite of it, that investors make money, over time, in the stock market.

What Are Your Goals?

Most investors have some kind of goal for their money. Perhaps the most common goal is retirement. You want to enjoy your new lifestyle, while not running out of money. The goal helps determine the risk levels appropriate for your situation.

For example, a big risk in retirement investing is uncertainty about how much spending is sustainable, over the course of your lifetime.

If you spend $50,000 a year, in today’s dollars, and you retire at 67, how can your portfolio generate enough income to maintain that level of spending? It’s not an easy answer, as the cash flow must be discounted for inflation into the future, and the proper growth rate must be determined.

That’s where portfolio risk level comes into play. Your portfolio should be designed to generate that income for another 25 to 30 years. It’s prudent to plan for a long life expectancy, even if your parents died young.

Stocks return more than bonds, which is why most retirees should ignore the old-fashioned advice to keep their money entirely in bonds. The boomer generation’s longer life expediencies mean the portfolio has several decades of double duty: It’s a source of living expenses, but must also grow in value.

That portfolio growth relies on risk. As the old saying goes, “No risk, no reward.” It’s the risk inherent in stocks that delivers that higher return.

Take A Good Look Into Your Portfolio

Historically, the return of stocks has outpaced inflation, which is good news for retirees, who no longer have an income from work.

However, it’s important to take the right kind of risks with your stock portfolio. One common mistake is to default to home-country bias. That means investing in just the stocks from one’s country of residence.

According to a 2016 study by the Vanguard Group, American companies account for about 80% of U.S. investors’ portfolio holdings. Similar phenomenon exist in other developed nations, including Canada, Australia, Japan and the U.K.

That concentration in one’s home country adds risk. If domestic stocks go into a sharp decline, you probably won’t have enough other holdings to potentially offset the risk and smooth out your return. Even in 2008, when every global stock market declined, some countries had smaller declines than others. It’s a given that you will see some years of losses over decades of investing, but global diversification will likely help stem those losses.

Another form of risk is stock speculation. It can be fun and exciting to purchase a stock and watch it go up, but that’s another of those activities that would be ubiquitous if it worked every time. Unfortunately, this type of trading is speculation, not investing.

While traders often use a set of “rules,” based on either technical or fundamental data, or qualitative factors such as news reports, the rules don’t always result in portfolio gains. It’s easy to get impatient and sell before a rally, hold too long and let paper gains slip away, or simply make the wrong bets.

Trading is fine if it’s considered entertainment, and if you carve out only a small amount of your overall portfolio and designate it “play money.” But this should not be part of the money allocated to your retirement goals.

Risk vs. Diversity

It also matters what kind of stocks you own. Smaller companies, called small caps, tend to carry more risk than their larger peers. Their prices tend to show greater degrees of fluctuation, which makes sense, as these have fewer shares outstanding and it takes a smaller degree of buying or selling to move the needle significantly.

Small caps also return more, making the risk of this asset class worthwhile. However, it’s unwise to simply load up on a better-performing asset class, as no one knows when it will go into decline, and another asset class will, for a time, show superior returns. That time period can last for months or even years.

Investors should also hold value stocks, which are simply those trading below their worth, based on company earnings. Because of this potential for a higher degree of price appreciation, value stocks outperform growth stocks, over time.

It’s important to understand what market risks are worth taking and which mostly serve to drag down returns. Work with a fiduciary planner to develop a portfolio that delivers the right risk-and-return equation for your situation.

Finally, resist the urge to tinker when you think markets are going either up or down and you want to make a bet on either side. Shuffling around portfolio holdings typically adds unnecessary risk, as well as piling on the trading fees.

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Better Money Decisions