Mitigating Risks in an Investment Portfolio
As I mentioned in the previous posting, investors face several forms of risk to their investment portfolios. These risks are the uncertainty that a portfolio will earn its expected rate of return. Risk can and will affect all asset classes within a portfolio (i.e. stocks, bonds, real estate, commodities).
As I mentioned previously, risk can significantly impact the ability of a portfolio to earn its expected rate of return. However, steps can be taken to mitigate these risks.
The first risk we discussed was market risk. Negative activity, such as significant across the board market sell offs, can impact a portfolio. This risk can be mitigated through portfolio diversification. In order to achieve this desired level of diversification an investor should look at including in their portfolio asset classes that generally do not move either up or down together. For example, we would expect stocks to move opposite of bonds. Usually factors that are positive for stocks are negative for bonds. Other means to attain diversification can be accomplished through investing in foreign stocks and bonds, or alternative investments such as real estate or gold. Diversifiers work well in normal market conditions. However, there are major events, such as the financial crisis of 2008-2009 where all these assets moved down together.
Sovereign risk is associated with government decisions that adversely impact the business-operating environment. The most effective means to mitigate sovereign risk is to conduct a thorough complete analysis of the country or countries an investor looking to to invest. This is a continuous analysis ensuring the investor remains current with the situation within a country. Additionally, diversification by investing globally can minimize the impact of sovereign risk from any one country on the portfolio.
Next is business risk. The most effective means to mitigate business risk is to diversify across industries and companies. In short, do not put all one’s proverbial eggs in one basket. For an example, an investor interested in the technology sector, investing in a basket of technology companies through an Exchange Traded Fund (ETF) could reduce the impact of a single company could adversely impact a portfolio.
Retirees generally suffer the most from interest rate risk. Retirees tend to hold predominantly interest-bearing investments with the intent to supplement their income with the interest these investments produce. These investments are generally considered conservative and/or safe in nature, they are usually government bonds and CDs and other interest bearing vehicles. The current challenge is that investors who hold these investments and are depending on them as income or as a supplement to their income may attempt to increase their income to acceptable levels by undertaking unacceptable risks given their circumstances. As they to seek more income they move into riskier assets such as stocks, real estate or other alternatives where short-term loss of principal is intolerable.
Inflation risk has the greatest effect on investors with long-term time horizons. History has shown the most effective counter to inflation risk is a portfolio of various assets that add value to a portfolio over time. The holdings of this portfolio are rebalanced to adjust to the economic circumstances that exist.
Liquidity risk is best mitigated by ensuring holdings in the portfolio are readily marketable. These are assets that can be bought and sold without significant effort on the investor’s part. As an example, if an investor sought income generation through exposure to real estate, holding a number of rental properties in the local area will provide that exposure. However, the ability to sell a particular property may be severely hindered if the local market is flat or in a down turn. Real Estate Investment Trusts (REIT), on the other hand, generate income from real estate exposure and are readily bought and sold on the stock exchange.
These are the general forms of risk that affect a portfolio’s performance. However, through prudent asset allocation across asset classes these risks can be mitigated. Resulting in an investor achieving their intended goals.
The content contained herein represents the author's opinion and should not be regarded as investment advice, which is provided only to Agnew Capital Management LLC clients upon completion of a written plan.