understanding portfolio risk

Evaluating the Place of Risk in Your Financial Plan

by Jay Bowen

Many people are daunted by financial planning. There’s a range of reasons for their anxiety, but the issue of risk stands out. For many individuals and couples, the potential of investing their hard-earned cash, only to lose some or all of it, is a frightening thought. As a result of this fear, many people miss opportunities to grow their wealth.

It’s important to understand that investment does involve risk, but risk can be managed: There are many ways to structure a financial plan to allow for growth while also minimizing the possibility of significant losses. Portfolio diversification is one way of managing, and even mitigating, risk. Working with a knowledgeable financial advisor is another way of responsibly managing your assets.

Understanding Financial Risk

You can also increase the amount of money you have in a variety of ways: Purchasing real estate, placing your funds in an interest-bearing bank account, starting a business, a direct investment in someone else’s business or investing your funds in the financial markets. Good investments grow in value, something that can allow you to fund your children’s college tuitions, enjoy a comfortable lifestyle, purchase a vacation home or even enjoy some “bucket list” items such as adventure travel. 

The difficulty is that there is often a correlation between an investment’s potential for growth and the risk of financial loss. While it is possible to earn interest at no risk to you by putting your money into an FDIC-insured savings account, the amount of interest you’d earn is remarkably small. On the other end of the spectrum, consider entrepreneurship risk: People who start their own businesses — a risky endeavor — can end up making huge amounts of money from their initial investment of time and capital (think Bill Gates, Sara Blakely or Jeff Bezos) if their businesses take off. The trouble is that these entrepreneurs are outliers, as most new businesses fail.

The same can hold true for financial products, such as stocks. The equities of large, stable, publicly traded companies can be costly, limiting how many shares you can purchase at one time. In addition, these shares may not have the same potential for growth as shares in newer, smaller, or currently underperforming companies. At the same time, purchasing stocks in less reliable businesses is often riskier, because they aren’t as stable and are more vulnerable to internal and external forces that can compromise the integrity of the company.

Here are some examples of things that can compromise the profitability, and integrity, of newer or smaller businesses:

  • Changes in the economy, including recessions
  • Poor internal management
  • Aggressive competition
  • Internal sabotage
  • Scandals involving ownership or management
  • Cash-flow issues that affect supply chains, costs, and product quality
  • Industrial accidents

Of course, large, stable businesses can also be affected by these things, but they often have the cash reserves, reputation, and access to crisis management services to address and recover from disruptive factors.

Portfolio Diversification

Many investors understand the necessity of risk when developing a financial plan, though they often take steps to mitigate it. The goal is generally to have the most positive outcome with the least amount of risk. One way of reducing portfolio risk is through diversification, or choosing to invest in a mix of financial products and other assets. By opting for a diverse portfolio, investors can take advantage of opportunities for growth while stabilizing their assets with more conservative, reliable investments.

It should be noted that diversification can be tricky, particularly when it comes to asset allocation, which requires investors to determine how much of their portfolio should be made up of a specific asset class such as stocks, bonds or commodities, for example. In addition, even very stable investments can be affected by systematic or unsystematic risk.

Systematic Risk

Systemic risk involves the ever-present risk of economic collapse that could be caused by what some analysts call “too big to fail” businesses. The financial brokerages that were heavily invested in mortgage debt in the late 2000s are a prime example of this: As firms failed, the entire economy was impacted and eventually governments had to step in to rescue some businesses and institutions to prevent the total devastation of the economy.

Unsystematic Risk

Unsystematic risk, on the other hand, is unique to the company or the industry in which the company operates. For example, an otherwise reputable company might be hobbled by a major product recall. Unsystematic risks in industries might take on the form of new technologies that cause a disruption or a shortage of raw materials that makes production difficult, if not impossible. 

A prime example of unsystematic risk due to new technologies is the fate of large chain video stores: The leadership of these companies didn’t grasp the e-commerce trend quickly enough, while an upstart company, Netflix, did. Eventually Netflix also seized upon the power of broadband internet and the capacity of most households to stream movies and other video entertainment. Traditional video rental stores eventually shut down entirely, though Redbox, an automated video rental vending machine company, continues to operate.

Because of this kind of unpredictable risk, it is important for investors to not rely on only one or even a few investment options. Crafting a diverse portfolio mixes investment classes as well as industries and companies and even regions.

Managing Risk: Getting Help

Financial professionals, such as the wealth advisors at Gratus Capital, can’t guarantee returns nor completely eliminate all portfolio risk. What they can do, however, is listen to you and learn about your goals, your concerns and the level of risk that you are comfortable taking at this stage of your life. They then apply their expertise to help you craft an investment portfolio that maximizes your opportunities for earnings while mitigating risk. 

Sources:

Why Some Startups Succeed (and Why Most Fail)

Explaining the Benefits of Investment Diversification

‘Too Big to Fail’: Can Regulation Control Systemic Risk?