Investment Risk and Risk Reduction Strategies

Personal Finance April 20, 2012 Print Friendly and PDF

Dr. Barbara O'Neill, Extension Specialist in Financial Resource Management

Rutgers Cooperative Extension

oneill@aesop.rutgers.edu

Did you ever wish that there was a “perfect investment”? That would be an investment that is risk-free, tax-free, and pays a double-digit rate of return. Unfortunately, it does not exist. Every type of investment product has some type of risk.  The types of risks vary for different types of investments, however, (e.g., stocks versus bonds). The causes of investment risks include inflation, economic trends, political uncertainty, business failure, and interest rate changes.

Business risk is the risk of loss when a company has poor performance or, worse yet, ultimately fails. Examples of the latter in recent years include Enron, WorldCom, Lehman Brothers, Borders Books, and Circuit City.  Interest rate risk is the inverse relationship between interest rates and bond prices. When interest rates go up, bond prices go down and vice versa. The reason bond prices go down when interest rates rise is that investors will only buy bonds at a discount if they pay less than current market rates.

Inflation risk is very common with cash equivalent assets. Especially today with extremely low interest rate, the after-tax return on certificates of deposit and money market funds is likely to be lower than the rate of inflation. This results in a loss of purchasing power. Another common investment risk is market risk, which is the risk of an investment (e.g., stocks) being affected by market trends.

One way to mitigate investment risk is to diversify your investments. For proper diversification, investors should select a variety of investments within the major asset classes (e.g., stocks, bonds, cash equivalents such as CDs and money market funds, and real estate). One way to do this is by purchasing 10-15 stocks in a variety of industry sectors such as health care, technology, and transportation. Another way to diversify is to purchase shares in a mutual fund that contains a diversified portfolio of securities.

Dollar-cost averaging is another risk mitigation strategy. This is when people invest regular dollar amounts at regular time intervals, such as $100 every month. Another example is having 6% of a worker’s pay placed in an employer retirement savings plan (e.g., 401(k) or 403(b) plan) every pay period.

Asset allocation is the process of dividing a person’s portfolio (the sum total of their investments, whatever the amount), percentage wise, into different asset classes. For example, 50% stock, 30% bonds, and 20% cash equivalent assets. Different investments are then purchased within each asset class. Aggressive investors will have more stock in their portfolio than moderate investors and moderate investors will have more stock in their portfolio than conservative investors.

A frequently cited guideline is “110 – your age” as the suggested percentage in stocks. For example, 110 – 50 (age) = a 60% stock allocation. At age 70, the stock allocation would be 40% (110-70). This guideline corresponds with recommendations to gradually decrease the percentage of stocks in a portfolio as investors get older (rationale: to shift to more income-oriented investments and because there are fewer years left to recover from stock market downturns).

Investment asset allocation is very much like a teacher’s grade book where various exams and assignments are worth a certain percentage of a student’s grade and are all averaged together. The weighted average reflects both the rate of return earned on investments and their proportionate weight in an investor’s total portfolio.

Rutgers Cooperative Extension has downloadable Excel spreadsheets to determine asset allocation percentages: http://njaes.rutgers.edu/money/default.asp.  Doing an analysis will help determine when it is time to rebalance your portfolio.  For efficiency, combine an asset allocation analysis with a calculation of net worth. You’ll already have current figures for investment values when you complete the “assets” section of a net worth statement so it won’t take much longer to determine the weights of asset classes.