How to Manage Investment Risk

by financialmom on June 23, 2011

in Financial Plan, Investing, Risk

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I had to use a picture of a Risk game board for this post, since my oldest son Nathan loved to play Risk when he was younger.  He and his friend Ben would play this game for hours, strategizing on how they could annihilate each other and control the world.

The essential question in the game of Risk is this – do you concentrate all of your men in one place, leaving yourself completely exposed everywhere else, or spread your men out over as many countries as possible?  (Think about this as you read the rest of the article.)

The previous post about risk, Why Investors Should Buy Risk, Not Return, said investors should control what they can about their investments.  Investors can control the amount of risk they take with an investment.  But how do you do it?  How do you manage investment risk?

There are many types of risk (which I will save for another post), and many ways to manage risk.  In this article I will focus on two very important ways to manage risk – having a diversified portfolio, and working with your financial advisor.

Diversification

You can attempt to mitigate  risk by making sure your portfolio (group of investments) is very broadly diversified across asset classes and countries. (Think not putting all your eggs in one basket.)

As simple and logical as diversification sounds, very few investors seem to do it. Investors have been told by the financial industry for years to “buy what you know,” and they have listened.  Typical portfolios are way overloaded with large growth blue chip type  company stocks (one asset class), because investors feel safe with corporate names they know.  Many company retirement plans are full of these types of funds, giving employees lots of the same stuff to choose from.

Overlap

What this leads to is owning the same companies over and over in a portfolio. Owning a bunch of different funds is not equal to diversification if all of those funds are of the same asset class. You likely are just buying the same companies over and over, if the funds are all the same asset class.

This is called overlap, and it greatly increases investor risk. Much of the reason this happens is a lack of investor education.  Not many investors even know what an asset class is, much less how to know what asset class a particular fund belongs to.

Here’s the big issue – we do not know which stocks or asset classes will do well in the future.  Oh, I know there are many talking heads in the media who will be happy to tell you which ones those are, but any momentary success is a matter of luck, not any proven skill over long periods of time.  Markets are random, and any specialized knowledge about an investment is already built into the price.

So what is an investor to do to manage risk? Since you do not know which stocks or asset classes will do well in the future, you should invest in all of them.  This will reduce your potential loss should any one stock or asset class lose substantially.  Here’s the positive part – it also makes sure you will participate in the gains of an asset class when it is having a big upswing.

What You Pay Your Financial Advisor For

Your financial advisor should be helping you manage another type of risk.  This risk is that your portfolio will not be able to meet the financial goals you have set with your advisor. This is what you pay your financial advisor for!  Your financial advisor should regularly monitor your personal situation for any life changes, your portfolio of assets, and your progress towards meeting your financial goals.

As the value of your portfolio changes, your advisor should be revising the calculation of how much risk you need to prudently take to meet your long term financial goals. Meeting your goals is not only dependent on the markets or how your portfolio is performing.  It also depends on how much you save and invest, and how much you take out of your portfolio once you retire.

One thing we do know – markets and personal situations change.  Having a financial advisor to monitor your situation is essential to your financial success because things do change. The important thing is good communication with your financial advisor, so your financial advisor knows where you stand, and can help you make smart decisions to keep you on track.

New Profile Pic 2599R How to Manage Investment RiskPamela Otten is CEO of Pamela Otten LLC, a Registered Investment Advisor. She loves to work with women business owners and entrepreneurs, and women in transition due to job change, death, or divorce. Pamela will help you set and reach your financial goals, educate you to understand your investments, and teach you how to do more charitable giving. Pamela is a Qualified Kingdom Advisor (www.kingdomadvisors.org), trained and committed to integrating biblical principles with her investment advice.

cc smallest How to Manage Investment RiskPhoto Credit – Bien Stephenson

Financial Planning, Investment Advice, and Investment Management provided through Pamela Otten LLC, Registered Investment Advisor.

The opinions voiced in this material are for general information only, and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, please consult your financial advisor prior to investing.

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{ 3 comments… read them below or add one }

OLga Hermans June 24, 2011 at 11:53 am

Yes, I know Pam that a financial advisor can change a lot of areas in your life, especially when they know you quite well.Like you said that good communication with your financial advisor is so very key in this whole process.

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Mindy June 24, 2011 at 3:42 pm

Great article Pam. Thanks for the insight. You’re website it looking fabulous. Great job!

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Vicky June 26, 2011 at 6:57 pm

Hey Pam, I love the Risk photo. I can always count on you for good info, thanks!

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