In our last piece, we described why most investors should ignore the never-ending onslaught of unpredictable financial investment news and tend to three strategies that can be much more readily managed – at least once you know they are there. Hidden in plain sight, these potent strategies include:
Don’t take on more risk than you must.
There is no getting around the fact that the market does not deliver rewarding returns without periodically punishing us with realized risks. That is why it’s so challenging for most investors to “be there,” consistently capturing available returns by remaining invested over time. It’s also why it’s vital to avoid taking on more risk than you must in pursuit of your personal goals. For this, we have two powerful tools at our disposal, best used in tandem.
Diversification: Eliminating Unnecessary Risk
Diversification helps you spread your risks around. If you instead concentrate your portfolio on too few holdings, sectors, or geographical locales, you may feel you’ve made smart selections when they happen to be doing well. But when bad news hits an undiversified portfolio, it often arrives without warning, and with a vengeance. That’s a real risk that investors too often ignore at their own peril.
For example, sometimes, tech stocks are red hot; sometimes domestic securities may seem safer than international choices – or vice-versa. Your company’s stock or a popular IPO (Initial Public Offering) may seem like a sure thing. But by trying to position yourself to catch the next trend or dodge some bad news, you’re also accepting the risk that your “sure thing” may fail you.
Decades of academic inquiry have informed us that, despite the risks, there are no extra returns expected by trying to consistently predict individual winners and impending losers. Instead, you are best off eliminating this form of risk by putting diversification to work for you.
Asset Allocation: Minimizing Unneeded Risk
While some risks can be diversified away, some remain. These are expected to enhance your long-term returns if you build them into your total portfolio and if you stay the course with them over time. They include a handful of factors, categorized into asset classes such as:
By blending a customized mix of riskier and less risky asset classes into your portfolio, you can seek to build wealth toward your personal financial goals while fine-tuning the risks involved. In contrast, chasing returns you don’t actually need can result in sacrificing what you’ve already accumulated if the risk is realized. Why go there?
Investment risks are most effectively managed by using the combined powers of diversification and asset allocation. Many investors believe they are well-diversified when they are not. They may own a large number of stocks or stock funds across several accounts. But upon closer analysis, the bulk of their holdings may represent one or two factors, such as mostly large-company domestic stocks. They may think they are managing their risks through diversification, but by failing to implement appropriate asset allocation, the excess risk remains.
If there is such a thing as a free lunch for investors, it’s enjoyed by making the best use of market risks and expected returns. Diversification helps you eliminate unnecessary risk – the kind that is not expected to improve your investment returns, to begin with. Guided by your financial goals, asset allocation helps you diversify appropriately to minimize unneeded risk and properly manage the market risks that must remain.
In our next piece, we’ll introduce one more plain-sight strategy for investment success: controlling the costs involved.
Douglas Finley, MS, CFP, AEP, CDFA founded Finley Wealth Advisors in February of 2006, as a Fiduciary Fee-Only Registered Investment Advisor, with the goal of creating a firm that eliminated the conflicts of interest inherent in the financial planner – advisor/client relationship. The firm specializes in wealth management for the middle-class millionaire.
Part 2: A Balanced Look at Stock Buybacks
Part 2: What’s Wrong with Depending on Dividend Stocks?
Financial Quick Takes: Making Mistakes
Do Downturns Lead to Down Years?
Sizing Up the Bond Market
Stock Gains Can Add Up after Big Declines
Help Your Child Become a Millionaire (Tax-Free, Too!)
Here’s How to Shock-Proof Your Retirement Plan
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