4 Steps to Manage Risk

1. Diversification

That classic saying “don’t put all your eggs in one basket” perfectly captures the essence of diversification, a fundamental strategy used to manage investment risk.

Diversification is the practice of spreading your investments across different asset classes (stocks, bonds, cash) and styles within those classes. It is important to remember that while diversification helps manage volatility, it does not eliminate the risk of loss if the overall market declines. The goal is to identify investments that perform differently under various market conditions so that when one "basket" struggles, others may remain stable or even grow.

For example, let’s say a stock portfolio included a computer company, a software developer, and an internet service provider. Although the portfolio has spread its risk among three companies, it may not be considered well diversified, as all the firms are connected to the technology industry. A portfolio that includes a computer company, a drug manufacturer, and an oil service firm, however, may be considered more diversified and reduce the impact of volatility.

Mutual funds and Exchange Traded Funds (ETFs) are common tools for easily achieving broad diversification.

Similarly, a bond portfolio that invests exclusively in long-term U.S. Treasuries may have limited diversification. A bond fund that invests in short-term and long-term U.S. Treasuries, plus a variety of corporate bonds, may offer more diversification.

The concept of diversification is critical to understand when you are evaluating a portfolio. Many investors believe they are well diversified when they are not. If you want more information on diversification or have questions about how your money is invested, please call us to review your situation.

2. Asset Allocation

One of the most important decisions you can make is asset allocation. Long-term asset allocation determines a great deal of your investment returns. It is the way you divide money between stocks, bonds, cash and other assets. Different allocation strategies produce different expected returns and risk levels. 

When financial professionals ask you questions about your goals, time horizon, and tolerance for risk, they get a better idea about what asset classes may be right for your situation. Based on these factors, individual investments are selected to support the overall strategy that will generate the highest possible return given the risk with which you are comfortable.

Only a handful of factors are expected to drive higher long-term returns. 

1. Equity Premium (Stocks vs. Bonds) Over long horizons, stocks have historically outperformed "safe" investments like government bonds. 

2. Size Premium (Small vs. Large) Small-cap stocks are generally riskier, less liquid, and have less access to capital markets than giants like Apple or Microsoft. Because they are more "expensive" to hold in terms of risk, investors demand a higher expected return.

3. Value Premium (Value vs. Growth) Value stocks are companies that trade at a low price relative to their fundamentals (like earnings or book value). Historically, the market has over-discounted these stocks, allowing them to outperform growth stocks which are often priced for perfection over long periods.

4. Profitability Premium Financial research shows that companies with higher direct profitability tend to produce higher returns than less profitable companies. When you combine this with the value factor, it helps filter out "value traps" (cheap companies that are cheap for a good reason) and focuses on high-quality companies at a discount.

Note: Asset allocation and diversification are strategies designed to manage investment risk, but they do not guarantee against loss.

 3. Rebalancing Your Portfolio

It is natural to want to hold on to investments that have performed well. However, doing so without adjustment can lead to unintended consequences. Over time, the performance of different assets can shift a portfolio away from its original intent and risk profile, a phenomenon often referred to as “risk creep.” This occurs when gains in certain investments cause the portfolio to become more concentrated in those assets, increasing overall risk beyond what was initially intended.

If all investments produced identical returns, the portfolio’s allocation would remain stable over time. However, because returns vary across asset classes, the portfolio’s composition can shift significantly, potentially diverging from its original allocation. This change may alter the intended risk profile and require periodic adjustments to support alignment with your goals. 

Market fluctuations can significantly alter the risk profile of an investment portfolio over time. For example, consider a hypothetical portfolio initially allocated 50% to bonds and 50% to equities. If equities outperform other assets over several years, the portfolio may become heavily weighted toward stocks, deviating from its original allocation. In such cases, adjustments may be necessary to restore the intended risk profile.

How Rebalancing Works

Rebalancing is the process of restoring a portfolio to its original risk profile. There are three primary methods to achieve this:

1. Contribute New Funds: When adding new money to a portfolio, distribute new contributions to asset classes that have declined in value. For example, if bonds originally represented 40% of your portfolio but have fallen to 30%, consider buying additional bonds to return to the target allocation. 
2. Sell Appreciated Assets: Another approach is to sell a portion of investments that have appreciated (“winners”) and use the proceeds to buy underperforming assets. This method effectively enforces the principle of buying low and selling high. However, it may trigger taxable gains, which should be considered before proceeding.
3. Adjust Across Accounts: Rebalancing can also be accomplished by reallocating assets within different accounts under the same household. For instance, if your overall portfolio is overweight in stocks due to market gains, you could sell stocks within a tax-advantaged account (such as an IRA) and purchase bonds there. This approach helps restore balance without incurring capital gains taxes in taxable accounts.

Regularly reviewing and rebalancing your portfolio to maintain your desired risk tolerance is a prudent practice, regardless of market conditions. Many investors find it helpful to review annually to determine whether adjustments are necessary.

It is important to remember that all investments carry risk. Decisions should be guided by your individual goals, time horizon, and risk tolerance. The value of investments and their returns will fluctuate with market conditions, and when sold, they may be worth more or less than their original cost. This example is provided for illustrative purposes only and does not represent any specific investment or strategy.

4. Asset Location: Tax Efficiency  

While allocation is about what you own, asset location is about where you own it to minimize taxes. Certain investments generate higher taxable income than others. To minimize tax impact, less tax-efficient assets such as taxable bonds or real estate investment trusts are often best placed in tax-advantaged accounts like IRAs or 401(k)s. Conversely, more tax-efficient investments, such as broad-based index funds, can remain in taxable accounts without significantly increasing your tax burden. 

While the principle is straightforward, figuring out the best asset location for your unique circumstances requires careful analysis. Factors such as account types, investment objectives, and tax considerations all play a role. Because asset location involves both strategic planning and technical expertise, consulting a qualified financial professional can help ensure your approach aligns with your long-term goals. 

Maintaining an investment strategy involves several key pillars beyond just choosing the right stocks and bonds. Using these core principles, you can better manage risk and optimize your long-term returns through diversification, asset allocation, rebalancing, and asset location.

Summary of Risk-Management Strategies