How to Manage and Reduce Risk When Investing
First of all, in order for you or I to successfully manage investment risks, we must be able to quantify and understand what in fact those risks are. We cannot and should not put our money into things without properly understanding where the dangers and potential impacts lie. With that in mind, one great way to evaluate risk is to examine the largest amount a particular investment dipped historically and then consider how long it took to recover.
For example, let's take gold, which experienced an enormous drop in the early '80s before taking roughly 20 years to bounce back to previous levels. Also—as many are aware—when the US stock market crashed in 1929, it didn’t rebound until 1954: 25 years later! Now, many of you may be thinking: Well, that could never happen again. To me, that is analogous with “experts” on the Titanic who said the ship would never sink—a foolish assumption! Even in recent years, the stock market was basically break even from 2000 to 2013, a 13-year period.
So, as we set out to manage and reduce risk, we must first understand associated risks, how to define them, and which metrics we'll employ to do so: step one in the process. After successfully completing this step, we can begin to imagine our approach for building a portfolio. Likewise, it is important to keep in mind that one of the best ways to manage and reduce risk is through diversification.
I have written and talked about diversification many times throughout my life, dating back to my teenage years when I was just beginning to learn about finance—or perhaps even younger, when my dad would quote
Ecclesiastes 11:2, which originated from a lesson shared by King Solomon. The verse essentially says, “Diversify your wealth seven or eight ways because you do not know what danger may fall upon the Earth.” Therefore, a great—and probably my favorite—way to manage risk is through diversification.
In fact, diversification is held so highly in my opinion that I even leveraged this approach in my emergency fund account rather than just sticking with cash: showing just how convinced and confident I am in its effectiveness. But what exactly do I mean when I say diversification works well?
In stating this, what I'm referring to is that diversification affords investors a smoother ride and less volatility in their account and net worth. When examining diversification, I look for historical performance (going back as far as I can), as well as short recovery times and fewer big drops than those observed in any one particular inflationary asset class[KM8]: such as gold, silver, oil, real estate and stocks.
With that being said, inflationary asset classes are historically volatile and can experience huge drops during certain types of economic disasters. Going back to portfolio diversification, this investment approach means you have non-correlated asset classes.
With respect to my own personal emergency fund, for example, I have global stocks, global bonds and gold. I also use long-term treasuries. Contrary to popular belief, gold has no correlation to stocks. On the other hand, long-term US treasuries share a negative correlation with US stocks—and the same holds true for the US total bond market and US stocks. Foreign bonds have no correlation to US stocks and global stocks at large. What does all this mean? Simply put, if you build a portfolio with non-correlated asset classes, your drops won't be that big, and your recovery time won't be that long.
If you employ truly non-correlated asset classes when building your portfolio, it might take you up to one or two years to break even historically: giving people in their 70s, 80s, or even 90s an opportunity to boast a portfolio that will in fact also lend them inflation protection and better growth than a cash account would.
With investment diversification now fully accounted for, it might go without saying that the next thing you can do to manage or reduce risk is to purchase the right products.
Fortunately, many types of annuities and structured products are available to help investors reduce risk: such as principal protected notes, equity link CDs and annuities. Beyond this, insurance and investment products can provide a varied slate of options. For example, you can buy one such product that will offer you 10% or 20% downside protection if you hold it for the term: meaning that if you purchase a principal protected note or an annuity that has a three-year commitment with 10% downside protection and participation in the underlying index of, say, 100% over the three years, the max it can go up is 100%.
Broken down further, if the index you're tracking rises more than 100% over three years, you are uninvolved in that activity. If at the end of three years, however, your annuity has decreased by 8% or the stock market or underlying index has done the same, you get all of your money back without the need to take any type of loss: in this case, dodging an 8% drop. In another example, let's say that at the end of three years, the index you’ve chosen to participate in or link the performance of your money to has dropped by 20%. Given the afore-mentioned three-year product with 10% downside protection, you would only lose 10% of your money rather than the full 20%.
These are just a few examples of how to reduce and manage risk using these innovative CDs, principal protected notes and annuities.
Buy Low-Risk Investments
Another way to address risk is to merely buy low-risk investments that offer low rates of return. After all, you can always bulk up on bonds, CDs, annuities and cash. However, are you really managing risk in this situation? What you're really doing, in many ways, is following your emotions as you scoop up all these bonds and CDs and annuities because you don't want to see your account suffer.
But the problem in doing so is that this also drives down your purchasing power, a risk that people do not take into account when they dump their savings into investments that offer little or no return. Here in the year 2021, bonds, of course, offer extremely low yields for investors. Right now, we're looking at a roughly 38 to 40-year bond bull market. As interest rates have gone down, bonds have skyrocketed and investors can't achieve the bond yields they’ve enjoyed for decades.
Imagine a scenario where you set out to reduce risk and put your money in bonds, CDs and fixed annuities. Not variable or variable-indexed annuities—just fixed annuities, which offer about the same payout as CDs do. However, their interest is tax-deferred, unlike CDs (wherein you must pay taxes on the interest every year). The same goes for bonds, excluding municipal bonds. Now, of course, if any of these investment types fall inside an IRA or retirement account, they’re tax-deferred. As such, I am referencing these types of investments outside of a retirement account and within a brokerage or taxable account.
But I digress. Now, let's say you have an account containing a bunch of bonds, cash, fixed annuities or CDs, and the government is busy printing money—trillions of dollars—driving up the value of the stock and real estate markets. So while all of your friends are boosting their purchasing power and equipped to keep up with price increases for consumer packaged goods and health insurance, you are forced to sit there with your money in bonds, cash, CDs or fixed annuities, unable to keep up with inflation.
Hence, you’re forced to lose your purchasing power and incur risk as you funnel too much money into assets that will not allow you to maintain or even improve said power over time. Taking a step back,
I believe the government will continue to print money as time marches on.
It's just the way they do things.
I also believe the government will continue to go further into debt: the traditional way our country is managed under the people we choose to vote for. As such, I believe that if someone sets out to construct a “safe” portfolio, he or she can do so with the afore-mentioned products and participate in global stock market gains with downside protection.
I understand that you may be extremely scared and concerned about doing this. Let me assure you, my personal favorite way to go about this process is through true class diversification using non-correlated asset classes. I truly believe this is the premier approach and what God would recommend. If you think I’m speaking in hyperbole, consider another part of the Bible. In the New Testament, Jesus teaches about talents he gifted various people. One such person took the only talent his master gave him and buried it in the ground.
Now, let’s imagine that this “talent” is money. When the master came and asked him for the money, the person replied, “Well, master, I took the money and buried in the ground so you won't lose any of it.” The master, in turn, became very upset and said, “You should have put the money in the bank so I can get interest. Now, I am going to take away what you have and give it to someone else who was a better steward with the money I gave him—a person who actually took risks and made even more money in return.” The moral of the story? Avoiding risk completely is just as unwise as a lack of diversification in your investment portfolio.
Talk with me
So, where to go from here? We are happy to perform a free portfolio evaluation if you're currently wondering if your approach to managing and reducing risk is a sound and effective strategy. Beyond this, we can also set up a 20-minute meeting—at no cost or obligation—to discuss where you are right now, where you want to be, and favorite tips I use with my clients to help them manage and reduce the risk in their investments at the time of retirement.
Also I encourage you to watch my free retirement video: https://go.thirdactretirement.com/strategy