Risk Management: The Key to Long-term Financial Success
- 2005 4 Nov
We hear this term all the time. But, what does it really mean? Risk, taken by itself means: danger; hazard; jeopardy. Management means running; administration; and supervision. Now, if you took those words separately and brought them together, you could say that risk management is running from danger. Of course, the "running" in this instance is actually referring to being in control, but given the current mood in the world, I thought literally running from danger (or hazard or jeopardy) was much more appropriate.
According to the IFCI Risk Institute (yes there is such a place. Is this a great country or what?), risk management is defined as: "The application of financial analysis and diverse financial instruments to the control and, typically, the reduction of selected types of risk." Huh? In layman’s terms, it means to not put all your eggs in one basket. Simply put, diversify.
As recently as the 1990’s, this philosophy was laughed at. Why diversify when all you have to do is throw a dart at a bunch of stocks and pick the one your dart hits? We have turned 180 degrees and the age-old use of diversification is once again chic. Warren Buffett, arguably the most successful investor in the world, was once asked about investing in a bull market. His answer: "A rising tide lifts all boats. It’s not until the tide goes out that you realize who’s swimming naked." Well, the tide has gone out, only unlike the tides, there’s not a predictable pattern.
Buffett has also said: "Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well…. In the short run the market is a voting machine; in the long run, it’s a weighting machine."He understands the importance of investing with a long-term frame of mind. He has also said "for some reason, people take their cues from price action rather than from values. What doesn’t work is when you start doing things that you don’t understand or because they worked last week for somebody else. The dumbest reason in the world to buy a stock is because it’s going up."
These are difficult times, but you must remember the reason you originally began investing. It was to build wealth for the future. We knew there would be bumps and although these bumps have become more like big hills to climb, we must still keep our focus on the end.
Finally, we can’t forget about that other detriment to growing our wealth and that is inflation. I know what you’re thinking. "What’s that?" Inflation has not been an issue in our country for about 20 years, but it has never gone away. Inflation is an incredible wealth inhibitor. It inhibits wealth more than taxes. Think about it. If you earned 5% in your bank CD and inflation was 0% and taxes were 50% (extremely high), your wealth would have increased by 2.5% (50% of 5%). If you earned 5%, inflation was 3% (which is the average inflation rate over the past 75 years according to Ibbotson & Associates), and taxes were 0%, your wealth would have only increased by 2% (5% - 3%). Historically speaking, according to Ibbotson & Associates, we know that the historical returns of various investment vehicles are as follows:
Compound Annual Return (1926 – 2004)
Muni. Bonds 4.6%
Gov. Bonds 5.6%
Note: Past performance is not indicative of future results.
As you can see, in the past, stocks have provided the best defense against inflation. Does that mean you should have 100% of your money in stocks? Not at all, but it does mean that stocks should still be present in your portfolio.
If the mantra in real estate is location, location, location, then the mantra in investing is diversification, diversification, diversification. Diversification does not eliminate risk or assure against market loss, but it can lower your risk, which over the long run may bode well for you. As we said in the beginning, proper risk management begins and ends with diversification.
With apologies to David Letterman, here is my top 10 list of principles for investing:
1. Realize that financial shocks, like high oil prices, are an integral part of the investing landscape.
2. Realize that there are many more financial shocks ahead - we just do not know where or when they are going to hit.
3. Realize that jumping out of the market during a crisis is the surest way to lock in losses
4. Realize that to time the market successfully you need to know something the market has not already priced - and most of us do not have that unique information.
5. Realize that even the best constructed portfolio cannot fully protect from financial shocks - but it can certainly mitigate their impact.
6. Realize that broad diversification across stocks, industries, styles, countries, asset classes and managers is the best way to control risk.
7. Realize that investing - particularly equity investing - is a long-term proposition.
8. Realize that investing requires discipline
a. Not making emotional and reactionary decisions
b. Having reasonable expectations for risk and return
9. Realize that discipline requires an understanding of an investors risk tolerance.
10. Realize that an investor in an overly aggressive strategy is the quickest way to destroy discipline.
One concept I share with our clients is the "Law of Large Losses." (I need to copyright that term). Whenever you lose money in an investment, you always have to make a greater percentage just to get even. For example, if I lose 10%, I have to earn 11% just to get back to even. If I lose 20%, I have to earn 25%. If I lose 50%, I have to earn 100% (essentially double my money) just to get back to even. I believe mitigating losses is much more important than trying to "hit it big." When does 100% - 50% = 0%? Only in investing. If I earn 100% on my money, but turn around and lose 50%, I end up where I started. If I have $100,000 and earn 100%, it doubles to $200,000. If I continue to invest and lose 50%, I’m back where I started ($100,000). By the way, it doesn’t matter if I lose the 50% first or second. If I have $100,000 and I lose 50%, I’m left with $50,000. If that $50,000 earns 100%, I’m back to $100,000. Math is funny like that.
The goal in investing should be to minimize risk without giving up all of your upside potential. There is no panacea for risk - risk must be accepted if one is to generate return. Good portfolio construction is designed to eliminate as much unrewarded risk as possible - and that is best done through prudent diversification of your assets.
Steve Scalici is a Certified Financial PlannerTM with Treasure Coast Financial. He is co-host of God’s Money, which can be heard on the internet at www.oneplace.com. You can contact Steve at firstname.lastname@example.org.