Risk Management Strategies
Austin Carroll is a financial advisor at Cornerstone based in Reno, NV. Austin has passed his Series 65 Securities Registration Examination. He has a passion for helping others achieve their financial goals and is excited to be a part of the Cornerstone team.
RISK MANAGEMENT STRATEGIES
When someone starts investing, one of the first things that an investor should do is identify their risk tolerance and how much loss they are willing to accept. A savvy investor can’t put together a solid retirement plan without acknowledging that the risk they are taking within their portfolio may decide whether they succeed in retirement. But how do you effectively manage risk in a portfolio? When it comes to managing risk, investors have four main strategies: avoidance, reduction, transfer, and acceptance.
First, let’s talk about the two main types of risk associated with investing in the stock market, systematic and unsystematic. The best way to think about systematic risk is the “system” as a whole. You can’t avoid systematic risk because it is essentially built into the broader market. There is a myriad of different variables that go into the current level of systematic risk, but it will always be there and can’t be diversified away. Unsystematic risk though is a level of risk that is associated with a particular company, sector, industry, or anything that can be individualized or categorized. Unsystematic risk is typically lessened through the diversification of the holdings within the portfolio.
The first way to manage risk is to simply avoid the risk. Most commonly, this looks like investors moving their holdings from equities to cash and cash alternatives. Obviously, if you are looking to avoid the risk associated with stocks then moving to cash will help but this does mean that you could be reducing one risk while simultaneously increasing another risk. Avoiding systematic and unsystematic risk by removing yourself from the market creates a new risk called purchasing power risk. Purchasing power risk is when your assets are no longer keeping pace with inflation, through the earnings you might gain in the stock market, and this is the biggest issue with simply holding cash in a high inflation environment.
Second, and the most common way to reduce risk, is reduction. While this seems obvious that we want to reduce risk, a better way to think about it would be diversification. Looking back at systematic and unsystematic risk we remember that systematic risk is always there, but we can reduce the unsystematic risk through diversification. Prudent investors will reduce risk through diversification by investing in counterbalancing industries or holding certain types of bonds that move in the opposite direction of equities.
Another way to manage risk is transferring that risk to another entity or person. For the typical retail investor this might look like something such as an annuity. While annuities come in many different forms, we are referring to the types that would guarantee an income or minimum returns. What you are doing with these products is transferring the risk of investing to the insurance company, who then will pay you a smaller but guaranteed amount.
Accepting the risk is the fourth strategy that we have to manage risk. While this isn’t an often talked about risk management strategy, it usually means that the investor is employing a buy and hold strategy of certain stocks and bonds. Whether it’s investing in an individual company or single sector of the market, this is not a very prudent way of investing and is generally not recommended for retirees or those approaching retirement because there is simply too much risk involved with this strategy.
At Cornerstone, we believe that managing risk shouldn't be difficult and each client's retirement plan should match up with their personal risk tolerance level. If you are interested in how much risk you are taking, or you are concerned that you are taking too much risk, we can help. Cornerstone Wealth Management can run a risk assessment to determine what your risk tolerance is and how much risk you are taking in your current portfolio.