Everyday life is the perfect illustration that risk is involved in everything we know and managing it is an action we address with everything we do. In our daily lives we may wonder about things such as: Should I take the umbrella today? Should we drive city streets or freeway to get to the doctor’s appointment? Which water heater should we buy?
Risk and Investment Decisions
Of course, risk is also involved with investments. But as with the examples above, there are steps we can take to manage and capitalize on the risk with which we are comfortable.
Three steps in the overall process of managing risk.
- The process of understanding the risk. This is done by gathering information or data to help make an informed decision. With investments we start this process by understanding our personal risk tolerance and time horizon.
- Understanding that there is a certain reward with each risk and assume the level of risk consistent with one’s comfort level as discussed in 5 Investment Risks.
- Respect history and the research/statistics available when taking action. This step is the act of managing. With the knowledge in the first two steps, one can decide which risks are appropriate to assume and how much one should assume.
Recognize Risk Factors
At Maxima Wealth Management we recognize the following principles that influence our structured approach to managing risk based on compensated risk factors:
- Markets work—Intense competition drives the market to near-instant efficiency. Securities prices are fair and reflect the best estimate of the company’s actual value. Efforts to identify undervalued stocks or markets are not rewarded consistently.
- Effective diversification is key—It reduces the impact of individual securities and enables investors to scientifically employ the risk factors that offer higher expected returns.
- Risk and return are related—Only non-diversifiable risk is systematically rewarded over time. So, differences in the average returns of portfolios are due to differences in average risk. Multifactor investing brings a systematic approach to harnessing these risks to deliver above-market performance over time.
- Portfolio structure explains performance—Asset allocation, not stock picking or market timing, accounts for most of the performance in a diversified investment strategy.
Research shows that most of the variation in returns among equity portfolios can be explained by the portfolios’ relative exposure to three compensated risk factors:
- Market Risk—Stocks have higher expected returns than fixed income securities
- Size Risk—Small cap stocks have higher expected returns than large cap stocks
- Value/Growth Risk—Lower-priced “value” stocks have higher expected returns than higher-priced “growth” stocks
Structuring a portfolio around compensated risk factors can change priorities in the investment process. The focus shifts from chasing returns (through stock picking or market timing) to diversification across multiple asset classes in a portfolio.
The key to managing risk is first to clearly understand what risk is, second recognize with every risk there is some level of reward, and third acting on what history has shown and what level of risk/reward you are willing to assume. It is important to stay focused on your investment goals and objectives along with your risk tolerance and time horizon.
Opportunity in the market is sometimes disguised as volatility. This can increase investor emotions and affect decision making. My next blog will address risk management from the behavioral finance perspective.