Key Takeaways
- All investments carry some level of risk, but a risk management plan will help you identify and mitigate those risks.
- An aggressive asset allocation is often recommended for young investors.
- As investors near retirement, a gradual shift to more conservative allocations is advised.
- Diversification is an essential part of a risk management plan and can be accomplished by investing in mutual funds and ETFs.
Definition and Examples of Risk Management
Risk management when investing is the process of identifying investment risk and determining the best way to address that risk. The goal of a risk management plan is to keep potential losses within a range that’s acceptable based on your risk tolerance.
In certain areas of your life, you may already practice risk management. For example, buying car insurance is a form of risk management because you’re reducing the financial impact if you get in an accident.
Insurance companies practice risk management by charging premiums based on the probability that they will have to pay one or more claims. They also insure large numbers of people, thereby making losses relatively predictable. Plus, each insured person usually retains a portion of the risk through co-pays, coinsurance, and deductibles, depending on the type of policy.
Note
Risk isn’t necessarily a negative thing. Taking on greater risks typically comes with the possibility of greater returns.
How Risk Management Works
Investors can approach risk management in several different ways, but in most cases, the process is the same: analyze and strategize.
Two popular metrics for analyzing a stock or fund’s risk are its beta and alpha.
Beta Coefficient
A stock or fund’s beta coefficient is a good way to gauge risk quickly. Beta measures how volatile a stock is compared to the overall stock market, typically represented by the . A stock with a beta of exactly 1.0 has the same level of volatility as the stock market. If its beta is less than 1.0, it’s less volatile. A beta above 1.0 indicates greater volatility compared to the market. For example, a stock with a beta of 1.1 is 10% more volatile than the stock market.
Note
Volatility is how widely the price of a stock or fund can swing—which indicates a potential for greater returns and greater losses.
Alpha
While beta measures volatility, alpha measures risk-adjusted performance. A positive alpha indicates that an asset’s return has exceeded its risk, while a negative alpha suggests that the return did not exceed the risk. Alpha and beta can be used together to determine if a particular stock or fund has been a good investment.
For example, if a stock has a 1.5 beta and the S&P 500 rises by 20%, you’d expect a return of 30% (20% x 1.5). But if you only earned a 25% return, the stock’s alpha is -5%. In other words, you weren’t adequately rewarded for the additional risk.
Types of Risk Management
Understanding beta and alpha can help you gauge an asset’s historical risk, but you’ll need to apply a risk-management strategy that protects against potential losses. Some of the more popular strategies are portfolio diversification, buy-and-hold, and equity glide path.
Portfolio Diversification
Having a diversified portfolio is also essential for managing risk. Investing in a single company or industry is risky. For example, you could potentially pick a poorly-run company or one that gets hit with an antitrust suit, even in an industry that’s outperforming others. Investing across the overall stock market reduces the risk. One way to diversify instantly is to invest in mutual funds or exchange-traded funds (ETFs).
Buy-and-Hold
Adopting a buy-and-hold strategy can also reduce risk over time. A Fidelity study of 1.5 million workplace savers found that people who kept their money invested after the stock market dropped by nearly 50% in late 2008 and early 2009 grew their account balances by 147% between June 2008 and the end of 2017. Those who cashed out of stocks in the fourth quarter of 2008 or the first quarter of 2009 earned average returns of just 74% through 2017.
Equity Glide Path
An equity glide path is a common approach to risk management that focuses on age-based asset allocation. Younger investors can often afford more risk because their money has more time to recover from losses. Someone in their 20s and 30s might invest aggressively by putting most of their money in stocks. As the investor gets closer to retirement, they’d shift money out of stocks and into safer assets with lower returns, like bonds and CDs.
For example, suppose you start at age 25 with 90% invested in stocks and 10% invested in bonds. But by age 50, you may have 70% in stocks and 30% in bonds. By age 60, your portfolio might be 50% stocks and 50% bonds and CDs, especially if you’re hoping to retire soon.
Note
Securities and Exchange Commission (SEC) regulations require mutual fund managers to disclose investing risks in the fund’s prospectus.
Types of Risk
There are many types of risks you face as an investor. The following are some of the most common types of investment risks, along with strategies that could help mitigate them.
Business Risk
If the company files for bankruptcy and you’re a stockholder or bondholder, you could be left with nothing after liquidation. The risk is higher for shareholders than it is for bondholders because bondholders get paid before shareholders in bankruptcy proceedings.
Diversification is the best strategy for reducing business risk. A good rule of thumb is to avoid having more than 5% of your portfolio invested in a single company.
Market Risk
Even when you invest in a diversified mix of financially sound companies, you face market risk, which is the risk of losing money because the stock market tanks. For example, the temporarily dropped 34% between February 2020 and March 2020 due to the pandemic.
Market risk is less worrisome for younger investors who have time to allow their portfolios to recover. But a prolonged downturn is a big threat for investors approaching retirement. Proper asset allocation and periodic rebalancing are vital to reducing market risk. Investing in stocks with a beta of less than 1.0 could also lower market risk.
Inflation Risk
Inflation risk is the risk that your returns won’t keep up with inflation. Your money will lose purchasing power as a result. This is a major concern for people who invest in low-risk assets, like bonds and CDs. The only way to reduce inflation risk is by investing in higher-risk asset classes such as stocks.
Note
Investing in dividend-paying stocks with a track record of regular increases can provide a safeguard against inflation.
What It Means for Individual Investors
There’s no way to avoid all risk, but a good risk management plan may help mitigate the potential damage.
Individual investors should think long-term when building a risk management strategy.
Young individuals might manage risk by starting with an aggressive allocation and gradually shifting to more conservative investments over time. Diversification is also key to risk management. Your risk management strategy will change based on your age and goals, so it’s essential to periodically revisit the level of risk in your portfolio and whether it’s appropriate for you.
As an investment professional with years of experience in financial planning and risk management, I can confidently guide you through the concepts outlined in the article you provided.
Let's delve into each concept mentioned:
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Risk Management: This involves identifying and addressing potential investment risks to keep losses within an acceptable range based on your risk tolerance. It's akin to various risk management practices in life, like buying insurance to mitigate financial impact in case of accidents.
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Asset Allocation: Tailoring your investment portfolio to include a mix of assets, such as stocks, bonds, and cash equivalents, based on your risk tolerance, investment goals, and time horizon. For instance, young investors are often advised to have an aggressive asset allocation, while those nearing retirement typically shift towards more conservative allocations.
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Diversification: Spreading investments across different asset classes, industries, and geographic regions to reduce the impact of any single investment's performance on the overall portfolio. Mutual funds and exchange-traded funds (ETFs) are popular tools for achieving diversification instantly.
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Beta Coefficient: Beta measures a stock or fund's volatility relative to the overall market. A beta of 1.0 indicates the same volatility as the market, while a beta above or below 1.0 suggests higher or lower volatility, respectively.
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Alpha: Alpha measures an investment's risk-adjusted performance. A positive alpha indicates that the investment has outperformed its risk, while a negative alpha suggests underperformance relative to the risk taken.
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Portfolio Diversification: Investing in a variety of assets to spread risk. This can mitigate specific risks like business risk, where concentration in one company could lead to significant losses if it fails.
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Buy-and-Hold Strategy: Holding investments for the long term to ride out market fluctuations and potentially benefit from compounding returns. Studies have shown that staying invested during market downturns can lead to better long-term outcomes.
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Equity Glide Path: A strategy that adjusts asset allocation based on age, gradually shifting from aggressive investments to more conservative ones as investors approach retirement. This approach aims to balance risk and return according to changing needs and time horizons.
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Types of Investment Risks: These include business risk (related to individual companies), market risk (overall market fluctuations), and inflation risk (loss of purchasing power over time). Strategies to mitigate these risks include diversification, proper asset allocation, and investing in assets that historically outpace inflation.
By understanding and implementing these concepts, investors can effectively manage risk and work towards achieving their financial goals over the long term.
