Understanding Investment Risk
Jeff Martin is a financial advisor at Cornerstone based in Reno, NV. Jeff has earned the Life and Health Insurance Licensure and has passed the Series 65 examination. He enjoys being able to help clients create customized strategies for their portfolios based on their unique financial goals.
UNDERSTANDING INVESTMENT RISK
For many of you, most likely all of you, this will be far from the first time you’ve heard us discuss risk and it will not be the last. In fact, quite the opposite. I assure you; the intention is not to be a nuisance or beat the topic to death, but it is critical to not lose sight of it if you are striving for financial success.
WHAT IS RISK?
It should be noted that all investments involve some degree of risk. In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investing decision. With this, as investment risk rises, investors seek higher returns to compensate themselves for taking such risks. I do not suspect this will come as a surprise in any way, and very much fits the mantra: higher risk, higher return; lower risk, lower return.
RISK & RETURN
If it were not for the risk component, there would be no (or very little) return. Much like you cannot have light without darkness, warmth without cold, etc. It is not that risk is a bad thing, we simply need to understand it. Beyond understanding it, the expectation should be to earn a fair rate of return based on the risk you are taking. This speaks to the efficiency or lack thereof in a portfolio.
AN EXAMPLE OF RISK
Say, for instance, you have two portfolios, and they both earn a 5% rate of return on average. Portfolio “A” has a potential downside of -20%, while portfolio “B” has a potential downside of -38%. One would likely be able to quickly deduce that portfolio “A” would be the more efficient of the two due to maintaining the same average return, while reducing the downside.
A COMMON INVESTING MISTAKE
A common mistake that many find themselves in is taking risks without getting paid for it. In many cases, this happens without the realization that it is taking place at all. The general culprits of this are often due to portfolio overlap and/or correlation. Portfolio overlap is when you have redundancies in the portfolio, (holding the same positions several times). This is common with the utilization of mutual funds as it can be very difficult, if possible, at all, to know EXACTLY what is in the fund. Typically, investment decisions are made based on the title of the fund, without a clear understanding of what is actually in the fund, resulting in taking more risk than what you are actually getting paid for. Correlation is slightly different in that it is when holdings move in coordination with each other. For instance, say you have large-cap stock, mid-cap stock, small cap stock, value stock, growth stock, and international stock, if there is significant pressure in the equity markets, it is likely all of the aforementioned stock will experience pressure.
DOES YOUR RISK TOLERANCE ALIGN WITH THE RISK YOU CAN AFFORD?
When it comes to risk, the individual, and the unique situation, there are two kinds of risk. The risk someone is willing to tolerate, and the risk someone can afford. The risk you are willing to tolerate is nothing more than how mild or wild of a ride you want to be on. Said otherwise, this is identifying your “uncle point,” or “how deep of a swimming pool you are willing to play in.” The risk that you can afford differs in that it identifies how much you can bear to lose before risking and/or forfeiting your financial security. In some cases, these will align, and in others, there will be a disparity between the risk someone is willing to take and the risk they can afford. It is critical to understand the two.
WHERE TO GO FROM HERE
At Cornerstone, we specialize in developing tailored retirement plans to our clients' wants and needs. A large part of this tailored retirement plan is the investment piece. We help our clients to identify their risk tolerance and how much risk they can afford to take when investing. Once we identify that, we create a plan to ensure that the risk exposure in their investment portfolio is in line with this risk tolerance that we identify. To see how our advisors can help you with the risk in your portfolio, call our office at 775.853.9033.
Based in Reno, NV, Cornerstone is for individuals and families looking to grow wealth, protect and preserve their life savings, and plan for the distribution of their estate in a tax-efficient manner through a tailored strategy. Schedule a time to discuss your financial goals with us.
This information does not constitute legal or tax advice. PCIA and its associates do not provide legal or tax advice. Individuals should consult with an attorney or professional specializing in the fields of legal, tax, or accounting regarding the applicability of this information for their situations.