How to Minimize Investment Risks Without Reducing Expected Returns
Most scenarios in life wch promishie a reward involve some element of risk. A football player with a contract paying him $500,000 a year has to weigh the monetary reward against the risk of being injured. He reduces the risk of injury by wearing protective equipment and by training his body to respond effectively and efficiently to threats and opportunities during the game. If he decided to play without a helmet or reduced the padding he wore, he would significantly increase his risk of injury without increasing his expected reward from the contract.
In the world of investing, protecting yourself against taking the kinds of risk which will not be rewarded involves three basic approaches:
- Smart Diversification
- Asset allocation
- Reducing costs
Although diversification does not eliminate the risk of market loss, it reduces the impact of the performance of any one company or market on your portfolio. Investors focusing their portfolio on a few select securities in an effort to own the right stock are akin to the player taking his helmet off to play - Significantly increased risk with no expected increase in return. Your investments should be diversified by geography (international as well as domestic markets), by economic sector (such as health or finance), size of stock (small cap versus large cap), and other factors to spread the risk. As the illustration below shows, a well-diversified portfolio can provide the opportunity for a more stable outcome than a single security. [pdf of graph attached – source: Dimensional Fund Advisors Canada]
Some argue that diversification will make you miss out on the potential rewards of backing the next Apple or Google, because you will not have a significant portion of your investible assets invested in one potential “winner”. Warren Buffett agrees, but he says, “If you are not a professional investor … then I believe in extreme diversification… maybe more than 99% of people who invest should extensively diversify.”
The challenge of asset allocation is to build a portfolio with the right mix of stocks and bonds that will give you the return you need and still allow you to sleep nights. Asset allocation must be aligned to your goals and objectives. For example, if you have recently retired and are drawing retirement income from your portfolio, you will probably have to adjust the mix of fixed income and stocks to reflect your changing needs and goals. These financial goals and the asset mix selected to achieve them should be spelled out in a document or an Investment Policy Statement (IPS).
The costs of investing—the fee structure of mutual funds, Management Expense Ratio (MER), sales commissions (load), and trading costs—can seriously erode portfolio returns. Attention should be paid to reducing expenses and stock turnover within the portfolio.
We are our own worst enemies
While costs are a factor in why individual investors achieve lower returns than the market as a whole, investor behaviour is surely the largest factor. In this column we have discussed various biases and the resulting behaviours that work against us: the equivalent of a football player playing without his helmet. As Benjamin Graham observes in his book The Intelligent Investor, “The investor’s chief problem—and even his worst enemy—is likely to be himself.”
How can you avoid getting in your own way to a more successful investment outcome? If you have paid attention to the three principles described above—diversification, asset allocation and cost reduction—your best bet is to put your statement in the file, and ride the markets out!
Jason Sirman is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada.