One of the goals of a diversified investment portfolio is to lower your risk of loss while increasing returns. When designing your portfolio, you evaluate the level of risk you can afford and are willing to take, your time horizon and desired return to achieve your goals. Using this information, you can develop a portfolio allocation for your situation. The next step is choosing individual investments. How can you choose investments and stay within your risk profile?
When investing, taking on more risk usually gives you the opportunity to earn greater returns. The key is to understand the risks and not be blinded by the projected returns. Before buying, step back, look at the risks and see if the expected return is in line with those risks. Let’s look at some of the major risks and how we can evaluate investments.
Market risk. Once you decide on a type of investment, you are stuck with the market risk of that asset class. In part, the stock will act like a boat on a rising and falling sea of the class performance.
Company risk. How the company performs is largely based on their management, operations, financial strength and position in the market. Some companies are more likely to deliver year after year, and carry less risk.
Social or political risk. Nationalization of an industry by government will result in significant changes in financial returns. Similarly, the backlash against smoking has changed cigarette manufacturers’ plans.
Interest rate and inflation risk are different but closely tied together. Consider the effect on your investment if inflation or interest rates rise.
Liquidity risk. If you need access to your money, how easy is it to get it without losing a significant amount or waiting a long time? For this reason, government money market funds are more liquid than hedge funds. They also have a lower expected return.
Credit risk. If the company or investment becomes less likely to pay you as scheduled, your risk of losing principal or payments increases. This can be difficult to assess as factors outside the company’s control can significantly affect their performance.
Once you understand the risks involved, you can compare the investments to see if the return promised is worth the risks. It is best to compare using “risk adjusted return.” You can obtain data and information on business practices using Morningstar, the Wall Street Journal, ratings agencies such as Standard & Poors, or other financial sources. Financial parameters such as Sharpe or Sortino ratios are available or can be calculated. Often there are competing factors to weigh to develop an overall risk rating. When you are done analyzing, you have the tools to determine if a CD with a higher return which requires you to hold it for a longer time, is not insured or is issued by a foreign bank is worth the extra risk. If you are working with an adviser, ask them to provide you with the risk adjusted return not just the published return. This will help you make better investment decisions and keep your portfolio within your risk comfort zone.
Tom Roberts, principal of A New Approach Financial Planning in Lakewood Ranch, can be reached at (941) 927-9590 or Tom@ANewApproachFP.com.