To borrow from my colleague, Tim Whitty, who asked this question as it pertains to your estate (click here to read), I’ll ask the same question as it pertains to your investments. Is risk management part of your portfolio? As one of the investing world’s original greats, Benjamin Graham said, “The essence of investment management is the management of risks, not the management of returns.” Regrettably too many investors worry about the risks when it’s too late. As I have heard in my past, “I want to be aggressive, but only when the market is going up!” Of course, that is what we all want; the problem is that no one knows when the market is going to go up and when it is going to go down. If we did, investing would be a lot easier. There are people who make a living forecasting exactly where the market is going to be at the end of the year; however, they are correct as often as a stopped clock is in telling time. As a consequence, building an investment strategy based on these prognostications is pointless.
While stocks offer growth potential, they are volatile and go up and down. To free yourself from this risk you need to put your money in a savings account, and we all know what these accounts are paying these days. In order to keep up with inflation, or to grow your investments above inflation, you need to take risk. Consider however that a 50% decline in your portfolio requires a 100% gain to break even. Therefore, risk management, or the reduction in volatility, is important. You need to make sure that when taking risk, you are compensated for that risk.
What does this mean? Simply put, diversify and always remain diversified. Make sure the sources of returns in your portfolio are varied. Holding a basket of stocks is better than holding one stock or “putting your eggs in one basket.” Additionally, holding assets other than stocks further diversifies your portfolio since stocks tend to rise and fall together.
This is where bonds and alternative assets come into play. Since many of these assets do not move in tandem with stocks, they can broaden the diversification and improve the return for the level of risk. Since returns for asset classes differ from year to year, there will be times when these assets add to growth and times when they detract. I touched on this topic in a previous blog (click here to read), but as a risk management tool, they are vital.
Most investors have been investing in bonds to lower risk for quite some time; however, alternative assets have only been around for a shorter period to most investors. Because of their importance in risk management, I think it is essential to get a better understanding of this diverse category of assets. In my next blog I will outline some of the key characteristics of the more commonly used alternatives.
Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
Rick Cloutier, CFA is the Chief Investment Strategist for Washington Trust Bank with over 20 years of portfolio management and investment experience. Rick designs and implements investment and risk management strategies for the bank’s clients. Rick has written numerous articles for Investopedia and wrote a weekly column for the Fall River Herald News in Massachusetts. His research has appeared in numerous journals, including the Journal of Investment Management and Financial Innovations, as well as, the International Journal of Revenue Management. He provided a nightly commentary on WALE radio and authored the novel Caveat Emptor. Rick earned his MBA at Boston University.