The most important thing to understand when building an investment portfolio is that all investments worth considering can and most likely will lose money at some point. Unfortunately this is just how it works. The key is to make sure that the different components of a portfolio possess risks that are unique and somewhat uncorrelated. This way, we decrease the chance of any one type of risk doing significant damage to our investment nest egg. By keeping this approach in mind, we’re less likely to fall into the trap of chasing returns and building a portfolio with more loss potential than we realize.
Without naming all of the risks inherent in stock market investing, suffice it to say that most of the risk is present over the shorter term. A multitude of reasons can lead to falling stock prices, which is why holding different types of equities can help to protect against some of the more specific perils that a particular sector or class of stock can face. As is the case now, U.S. stocks can be up nicely while emerging market equities struggle. Since consistently forecasting which will be stronger over the next three months is virtually impossible, the best approach is to spread an equity investment across multiple categories.
The same goes for bonds. Holding short term bonds can better protect you from interest rate increases, while high quality longer term bonds generally do a better job of protecting your money in a falling stock market or weakening economic environment. Lower grade bonds that offer higher yields typically do well when the economy and markets are thriving, but hold greater risk of loss when things weaken. In a poor economy, the weaker companies run a greater risk of defaulting on their interest payments.
Alternative investments typically expose themselves to a different set of risks. One example would be trend investing. Trend strategies will typically struggle in environments that are choppy and volatile, but excel once a clear trend is established, either up or down. Typically other asset classes are doing fine when a trend model struggles, highlighting its diversification benefits. Other types of alternative approaches can take a longer term view of risk and can be either in or out of the market for longer periods of time in an effort to minimize risk of loss. The downside here can be two-fold. When stock markets are up, the model may not be due to it being early to exit a rising stock market. On the other hand, it could experience market losses as a result of being early to enter a falling market. However, these risks typically occur at different times than those inherent in other asset classes in the portfolio and can be a great diversifier over time.
So in seeking to achieve solid long term growth while minimizing the risk of loss over time, don’t focus on avoiding risk. Rather, embrace many different types of risk without being overexposed to any one of them. This rule needs to be adhered to regardless of how any particular asset class has performed lately or how we feel it should perform going forward. We just never know which risk will materialize next.
