What is Financial Risk Management?
According to Wikipedia, risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability or impact of unfortunate events.
When it comes to your money, an unfortunate event could be a significant downturn in the market that lasts for one or more years. Or, it could be bad news for a stock you own that causes its price to plummet.
Types of Financial Risks
Most people associate risk with major declines in the stock market – for example in 2000-2002 and 2008. However, there are several other forms of risk that impact your financial well-being.
- A major decline in the stock market is the most visible form of risk
- Rising interest rates is a form of risk when the prices of existing bonds decline in value
- Your biggest personal risk might be your failure to achieve your financial goals
- Another form of personal risk is running out of money late in life when you have very few options
What About Down Markets?
We know mathematics work against you in down markets. For example, if you invested $100 and it declined in value to $50, you are down 50%. Because you have a reduced asset base, you have to go up 100% to achieve a zero rate of return. And, this return does not reflect the impact of inflation, taxes, and investment expenses.
What About Market Timing to Minimize Risk?
There is no crystal ball that helps advisors predict the future performance of markets – up or down. However, some advisors continue to claim they can time the future performance of the securities markets – that is, sell near market tops (highest prices) and buy near market bottoms (lowest prices).
This can be an effective sales pitch because some investors would like to believe it is true. But it is not true because market tops and bottoms are not predictable. Advisors may get lucky from time-to-time but is not an effective long-term strategy.
The truth is most advisors who practice timing sell after the markets reach their tops and buy after the markets reach their bottoms. This happens because the markets tend to move in short spurts – for example, after a lengthy market decline, the Dow Jones Industrial Average is up 1,000 points in a matter of days.
What About Passive Management?
If active portfolio managers are trying to beat the performance of the stock market, then passive portfolio managers are trying to match the performance of the market.
Active managers have to take more risk when they attempt to beat the market. You are rewarded for the extra risk if they outperform the market. You are not rewarded for the extra risk if they lag the market.
Passive managers take market risk, but they do not take the extra risk associated with trying to outperform the market.
What About Diversification?
Let’s assume there are concentrated portfolios (20 stocks) and diversified portfolios (100 stocks). Each stock in a concentrated portfolio may represent 5% of your holdings. Whereas, each stock in a diversified portfolio is 1%.
In a concentrated portfolio, a losing position impacts 5% of your assets. In a diversified portfolio, the impact is only 1%.
What About Global Investing?
You maximize diversification when you invest in asset classes that do not go up and down at the same time.
We live in a global economy so what happens in Europe or Asia impacts the U.S. On the other hand, if you want to pick the best companies in particular industries, they may be headquartered outside the U.S.
The best companies tend to defend their prices better in down markets so there are some definite risk management benefits when you invest globally.
What About GlidePath?
At GlidePath we understand there is a balance between managing risk and producing performance. The challenge is to provide both from the same portfolio at the same time. This relationship is frequently referred to as risk & reward.
GlidePath believes your best solution is a globally diversified portfolio of exchange-traded funds.
Each GlildePath client tells us their risk tolerance as part of the onboarding process. We build a portfolio that is tailored to fit their goals, circumstances, and tolerance for risk.