Your Four Must-Dos to Manage Risk and Maximize Returns

Your Four Must-Dos to Manage Risk and Maximize Returns

Risk is a necessary, but manageable, part of investing.

Investment management can be a complex undertaking, but one that has potential to yield great benefits. The key to investment success is recognizing that chasing high returns involves also assuming some risk. Many investors struggle to achieve this goldilocks balance.

At its core, risk management is the practice of embracing uncertainty and accepting it as an essential part of the investment process, then using a set of tools to offset it as much as possible. There are two basic types of risk – systemic (inherent in the markets) and unsystemic (can be reduced through diversification).

Below, we will walk through the challenges of effective risk management and outline strategies to overcome them. We’ll provide a knowledge base that allows you to confidently balance risk and return and make smarter investment choices.

Identify and assess risk

There are a wide variety of risk factors out there, and it’s important to be familiar with them. Here are some examples of systemic risk – risks inherent in the market that can’t be changed:

• Market risk: When the market price of securities changes.
• Interest rate risk: When interest rate levels change.
• Inflation risk: When inflation and a decline in purchasing power bring down an investment’s returns.

And here are examples of unsystemic risk – risks that can be managed through sound financial decisions:

• Credit risk: When a borrower doesn’t meet a contractual obligation.
• Business risk: When a company fails to operate profitably.
• Liquidity risk: When an investor quickly converts investments into cash, contributing to uncertainty.

Some investments are relatively risk-free, such as U.S. Treasury bills, and others are far riskier, including real estate in high-inflation markets. The more you familiarize yourself with the various types of risk – and understand that it’s intimately tangled up with return – the better you’ll be able to navigate it.

Diversify to manage risk

Diversification is an essential tool in managing risk. When you spread investments across a variety of industries, asset classes, and geographies, you create a safety net that keeps weaker assets from dragging down the whole portfolio. This is known as a defensive investment position. The alternative is to aggressively invest in companies that are profitable today, keeping in mind that their fortunes could change at any moment.

Here are the most common diversification options:

• Across companies: While it’s tempting to join up with the dynamic CEO of the moment, those leaders can quickly change, as can a company’s fortunes, so it pays to put your eggs in many corporate baskets.
• Across industries: If you buy stock in tech companies, you may also want to balance it with investments in industrials, energy, and the financial sector. If one industry heads into rough waters, there’s a good chance others will stay healthy (and perhaps even go up due to these troubles).
• Across asset classes: Investments don’t begin and end with stocks. Bonds, ETFs, and real estate are just a handful of alternatives.

Keep in mind that every investor is different, and so is every diversification plan. One investor may include retail, consumer staples, and transportation stocks alongside government- and corporate-issued bonds, cash, money market accounts, and alternative investments.

Manage risk with asset allocation

Asset allocation helps align your individual risk tolerance with your investment goals by distributing your funds across various investment vehicles. The three major types – stocks, bonds, and cash – each have their own role to play in this process. They usually work independently of each other, so if one dips, the others will often provide balance (which means you sleep a little more soundly).

Here’s more detail on each class:

• Stocks: Stocks tend to have high risk in the short term, but also offer the possibility of high returns. Large company stocks tend to lose money, on average, in one of every three years, but the consensus seems to be that, over time, there are long-term benefits to these investments. Stock comes in two basic forms: common stock and preferred stock. Common stock has higher risk but confers voting rights; preferred stock has no voting rights but gets paid dividends first.
• Bonds: A bond is a loan you give to a corporation or governmental organization that has a set expiration date and interest rate. The issuer eventually pays you back with interest, or you can sell it on the open market. Bonds come in three varieties – short, intermediate, and long term. They don’t have the growth potential of stocks but are generally considered safer investments.
• Cash: This is the safest form of investment but provides the weakest returns. Cash options include savings deposits, money market accounts, certificates of deposit (CDs), and treasury bills. These investments are almost always guaranteed by the U.S. government, but there is risk of inflation rising faster than your rate of return.

When figuring out how to allocate your assets, be sure to keep your long-term objectives in mind, as well as your appetite for risk. If your old Toyota is on its last leg and you want to upgrade to something new and splashy, then a conservative mix of cash, CDs, and short-term bonds may be your best bet. If, on the other hand, your focus is planning for retirement, you are playing the long game and so should lean more toward stocks.

Review and rebalance your portfolio regularly

Even the best portfolios need regular care and attention. It’s important to periodically meet with a financial advisor to go over your investments and rebalance if necessary to make sure you are meeting goals and staying within desired risk levels.

Luckily, there are established benchmarks out there to help you keep everything balanced:

• Sharpe ratio: This is a long-standing, popular method to measure risk-adjusted relative returns. It looks at a fund’s past performance and its projected returns and evaluates it against traditionally safe options, like treasury bills or bonds. It can also help determine whether success is a result of careful planning or pure luck.
• Standard deviation: This method uses statistics to calculate historical volatility. For example, if the standard deviation of a particular security is high, it carries higher risk. So, your personal desire for a low or high standard deviation will vary depending on your personal appetite for risk.

The benefit of these tools is that they take at least some of the guesswork out of investments and give you the power to make informed decisions.

Embrace the uncertainty

Risk and reward are intimately tied together, and one could not exist without the other. A proactive approach to investment risk will ensure long-term financial stability and success.

The strategy is simple yet powerful – identify areas of risk, diversify to minimize its impact, allocate your assets to ensure robust growth, and periodically evaluate the whole mix to make sure it’s all working smoothly.

Our team at Avior Wealth Management has over 100 years of collective wealth management experience and can help you make sense of your investments, whether you’ve gradually accumulated them over the years or recently inherited them. Take the first step toward purposeful investment by connecting with our team today.

Disclaimer: Nothing contained herein should be construed as legal or tax advice. Avior and our Advisors will work with your attorney and/or tax professional to assist with your legal and tax strategies. Please consult your attorney or tax professional with specific legal and/or tax questions.