Risk and Investing
As you manage your investments and look toward your financial future, it’s important to gain a solid understanding of risk and how it
affects you as an investor. The word “risk” often appears in financial discussions and it can be confusing and even intimidating. No
matter what type of investor you are or where you keep your retirement savings, you are assuming a certain amount of risk. In the
investing world, there are two basic components of risk. First; risk can be viewed as a chance to lose the amount of your investment, in
exchange for the chance of significantly increases. Generally, the greater the chance of losing your investment, the greater the chance
of making more money from the amount you originally invested.
Second, risk is always associated with volatility. The more an investment is volatile, the more significant the swings between gains and
losses in your investment over a given timeframe. Volatility goes hand-in-hand with risk. The more the risk, the more volatility.
The key to risk, as it pertains to investing, is to understand what type of investor you are conservative, or lower tolerance for risk to
aggressive, or higher tolerance for risk and what types of investments fit your risk tolerance level.
The first step is to realize any financial decision involves a certain amount of risk. The most conservative investments have
traditionally been those that are insured or guaranteed by the United States government. An example would be a Treasury Bill or Bond.
Examples of more risky investments would traditionally be international equity and small company stock funds. The chart below briefly
describes and ranks the level of risk and volatility of several of the most commonly available assets classes in employer sponsored
retirement plans.
| Asset Class Categories |
| Higher Risk/Return |
| International Equity |
|
These types of investments own shares in companies that are headquartered outside of the United States. In general these options carry more risk, can experience more volatility and have the potential for higher returns than US equity options. |
| Small/Mid Cap US Equity |
|
These types of investments generally own shares in US based companies that have market caps between$300 million and $10 billion. These investments generally carry a higher degree of risk and potential of return. |
| Large Cap US Equity |
|
These types of investments generally own shares in US based companies that have market caps above $10 billion. These investments generally carry a higher degree of risk and potential of return. They may be a good addition to your portfolio if you are years away from needing to access the funds. |
| Fixed Income |
|
These types of investments include loans to companies or government entities. They generally carry more risk than cash equivalents, but less than stocks. There values do fluctuate, but generally not as much as equities. |
| Short-Term Fixed Income |
|
This asset class includes investments that can be quickly turned into cash without losing much value. Examples include Treasury Bills, Certificates of Deposit (CDs), and Money Market instruments. In general, they are viewed as the least risky and lowest yielding investment options. |
|
| Lower Risk/Return |
After familiarizing yourself with the risks associated with different asset classes you might be wondering if there’s anything else you
need to be aware of before making any investment decisions. And for that matter, what do you do now that you know different asset classes
have different amounts of risk? Do you go for the safest and accept that you might see lower returns or do you invest more aggressively
and accept the highest return possible and the volatility that goes with it? Is there a way that you can have the best of both worlds? In
other words, can you combine both higher and lower risk investments to both lower your total investment volatility and increase your
potential returns?
The answer to all of these questions is an investment strategy called diversification. Diversification is a technique where you distribute
the assets in your account across several different types of investments. A number of studies have shown that proper diversification can
maximize the return potential of your investment portfolio for the risk taken. However, diversification is not simply casting your net as
wide as possible. The choice of asset classes to invest in, and in what proportions will determine the amount of risk in your total
portfolio. It’s also important select your portfolio based on your tolerance for risk (i.e. a person’s willingness to take more of a
chance for a loss of investment for a larger gain over time) and your time horizon (i.e. when you will need to access the funds in your
account).
At this point, you might be asking how you figure out if you should employ a more aggressive or conservative strategy and how do you build
a conservative/aggressive portfolio? Generally, the more time you have until you use your retirement assets the more aggressive investment
strategy you can employ. This is because you have more time to endure short term market volatility and therefore, if you are comfortable
doing it, you can focus on long-term growth. As mentioned above, the higher amount of risk you are willing to assume the higher potential
reward/return you may experience and vice versa as you pursue more conservative investments. As you might suspect, the more aggressive
investments have historically been highlighted by periods of volatility that the investor with a short term horizon (one to five years
before you will need your retirement assets) may want to limit or avoid depending on their personal situation.
For example, over the last 15 years the S&P has returned an average annual return of 11.84%, the Lehman Brothers Aggregate Bond Index has
returned approximately 6.60%, and while 3 Month T-Bills have returned 3.97%. However, if you look at a shorter period of time, in this
case a single year, the largest increase and decrease each segment has experienced was +37.58% and -22.1% for the S&P, +18..47% and -2.92%
for the Lehman Brothers Bond Index and 5.66% for 3 Month T-Bills (Note: T-Bills did not have a down year during the period). These time
based “returns” highlight the importance of understanding your risk tolerance when determining the make-up of your portfolio.
To determine if you are a conservative or more aggressive investor you must fully understand your personal level of risk tolerance. There
are a number of different components that that are often used to establish your risk tolerance rating including the following:
-
Time Horizon – How much time do you have until you will need to access your retirement savings?
-
Volatility Tolerance – Are you comfortable investing during market downturns or do you pull everything out at the first sign of trouble?
-
Personal Situation – Are you well ahead or well behind in saving for your retirement goals.
We have provided two simple allocations to describe the differences between a more conservative, lower tolerance for risk investor and a
more aggressive one. Investor A has more than ten years until they will need to access their account is comfortable investing for the
duration of their career and is willing to endure short-term market volatility in exchange for the possibility of higher long-term returns.
In this case, Investor A might want to consider employing a more aggressive investment allocation like the one below. (Please Note: This
allocation does not represent a recommendation of advice by Smart401k, is not tailored to your specific situation and may not be proper for
your situation).
More Aggresive Portfolio
Investor B has less than ten years until they will need to access their account, has been an active investor for their entire career and
is more comfortable with a more stable account and is unwilling to endure short-term market volatility in exchange for the possibility of
higher long-term returns. In this case, Investor B might want to consider employing a more conservative investment allocation like the
one below. (Please Note: This allocation does not represent a recommendation of advice by Smart401k, is not tailored to your specific
situation and may not be proper for your situation)
More Conservative Portfolio
Defining what type of investor you are, understanding your timeline for growth and finding the most appropriate funds for your personal
situation are key to successful long-term investing. Generally, spreading your risk across a wide, but well-researched group of funds
minimizes your risk as an investor. By making wise decisions that balance risk, an investor can increase their ratio of return to risk by
enjoying the benefits and growth of the market without undue exposure to potential pitfalls. Smart401k helps individuals position
themselves to benefit from the strengths of the investment market without being subject to unintended risk.
If you would like assistance with defining your investment risk tolerance, you may want to consider a service like Smart401k. Our business
focuses on helping clients define their risk tolerance, as well as advising them on how to build a diversified portfolio within their
retirement account. For more information on how to get started, please visit our website at www.smart401k.com or speak live to an advisor
at 877-627-8401.
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