Whether you have $100 or $1,000,000, you want to see your investment grow. Ideally, you would like to see that money grow a lot without the investment risk. Unfortunately, the risk/return tradeoff concept in investing tells us that greater returns come with greater risk. There is no magic formula that will allow you to guarantee market-beating returns without taking on some investment risk.
However, it’s important to understand that investment risk doesn’t have to be scary. Instead, managing that risk is what is really important for building a successful portfolio that will help you meet your long term goals. In this article, we will discuss how you can balance investment risk with the potential for future returns and watch your portfolio value grow over time.
Dollar Cost Averaging
Dollar cost averaging is an important investment concept that can help you smooth out the peaks and valleys of the economic business cycle. In using this strategy, you make deposits into your investment portfolio regularly over time, rather than investing a lump sum. This strategy aligns with how we pay the rest of our obligations in life and underlines the old adage of ‘pay yourself first.’ Not only is it an easy way to approach investing (you’re not putting off investing waiting for some bonus or other windfall but instead paying yourself like you do your garbage man or phone company), but it can also help reduce the impact that market volatility has on your portfolio.
This style of investing will mean that you are making deposits into your portfolio throughout all periods of the economic business cycle. As a result, you will end up buying into some investments when they are low and affordable and continue investing as the values increase. In these times, your average investment cost will be lower than if your bonus happens to show up during a market high. The other side of this equation is true also – if you invest regularly and the markets are high, you may be buying some expensive assets, but the key behind dollar cost averaging is in the last word: averaging. In taking timing out of the equation, you are averaging these highs and lows.
Build a Diversified Portfolio
No one has a crystal ball and can claim to know which investment will perform better during any given period of time. Because of this, most financial planners will recommend using asset allocation when building an investment portfolio. Asset allocation is simply an investment strategy that seeks to use different classes of assets to diversify a portfolio’s overall volatility and return over time, with the goal of lowering overall investment risk. Traditionally, these asset classes are broken down into equities (both foreign and domestic), fixed income (foreign and domestic), alternatives (real estate/commodities), and cash or cash equivalents.
Various asset classes offer diversification in both the returns and the volatility they can bring. These differences can be measured and used to balance investment risk versus reward for the portfolio. The amount of risk/reward you want to take will depend on a number of factors, including your risk tolerance (ability to sleep at night when the market is declining), goal for the growth of the portfolio and your time frame.
While the concept of diversification is fairly well-understood by investors, many people fail to understand how to maintain diversification within their portfolio and keep their investment risk within the target that they originally set. Given that some asset classes have greater potential returns (and volatility) than others over time, we would expect to see those higher returning classes take on a larger percentage of the portfolio than originally allocated. In order to keep your portfolio within your original risk/reward level, you must also perform regular portfolio reviews and rebalance the portfolio from time to .
Allocate Investments According to Time Horizon
Every investor has different goals and timelines. Having a clear understanding of what your goal is and when you want to reach it is one of the most important aspects of investing (and arguably, of the work we do with our clients). While no one wants to see their portfolio experience adversity, the reality is that the amount of investment risk you can afford to take is much different if your goal is 30-years away vs. 5-years away. Allocating your portfolio according to your time frame is one of the best tools available when managing risk with future returns.
How is this done? Investors reduce overall volatility by choosing how much to invest in growth asset classes (equities/alternatives) vs. fixed income (bonds/cash equivalents). As you approach the timing of your goal, you might choose to reduce your portfolio’s volatility. Generally, you can accomplish this by increasing your allocation of fixed income investments and decreasing your allocation of growth investments. By doing this, you essentially tighten the range of volatility in your portfolio. Upside growth is reduced with modest potential gains, while downside risk is reduced to help avoid a substantial decrease in value.
Time in the Market Beats Timing the Market
It’s an old standby phrase used by investors around the world – but what does this have to do with risk? The truth is, one of the biggest risks to your investment portfolio can be you. Despite the best laid plans, investors can often be driven by emotion. In some cases, this may mean selling investments during a period of instability and taking a loss instead of sticking with a plan. In other cases, it could mean chasing gains in certain industries and allowing the portfolio allocation to drift away from what you originally intended.
When you develop an investment plan, it’s important to see that plan through to the end. Simply looking at the historical chart of the S&P 500 shows that sticking it out through the tough times can lead to significant gains when the economy is doing well. Trying to time the market and jumping in or out at the perfect time can often lead to frustration and nearly always leads to lower returns over the long term. There will be good years and there will be bad years, but history tells us that an upward trend over a long period of time is to be expected.
During the Great Recession, our clients were scared. We spent countless hours in meetings, on phone calls and responding to emails to talk through their experience. In every case, we encouraged them to hold on. In most cases, they listened. They turned off the news and they let their portfolios weather the storm. These clients still tell us today that being there during that challenging time was some of the greatest value we added to their financial lives. In some cases though, the anxiety was too much and they couldn’t help the draw toward the “safety” of cash. To the letter, every one of our clients who liquidated during the Great Recession is worse off today than they would have been had they left their portfolio to ride it out.
Build a Plan and Stick to It
Balancing investment risk and returns comes down to building a successful, proven strategy and sticking with it. This is true regardless of your age, investment timeline or personal risk appetite. We spend our days working with our clients to create their own unique plans and manage their investments wisely over time. If you have questions about investments, risk management or comprehensive long term financial planning, reach out. Our team of CERTIFIED FINANCIAL PLANNER™ professionals is happy to help.