Managing Risk Means Managing Expectations

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When talking about investments, you’ve probably heard that higher risk means higher returns. Of course, since the future is unpredictable, it really means the expectation of higher returns.

Essentially, investors expect to be paid to take on higher risk. Investors purchase stocks and bonds hoping to make a profit on their investment. In the case of stocks, they expect a capital gain as the stock price increases, and in the case of bonds, they expect income based on coupon rate of the bond Investors demand a higher return – the expectation of greater price gains on stocks or higher yields on bonds – for taking on greater risk.

Risk is one of the most critical variables when it comes to investing. Uncertainty or pessimism can cause prices to decrease, allowing for a higher potential return. When those conditions change – when people are optimistic about a company or the economy – prices might rebound, assuming the underlying fundamentals remain intact.

With risky stocks or bonds comes price volatility, the daily zigs and zags typical of the market. But how can you protect your portfolio from day-to-day market fluctuations?

Here are a few common strategies that investors may use to protect their portfolios from market volatility:

  • Embracing the volatility: High risk can be mitigated with a longer time horizon, as the daily ups and downs become less important than your eventual destination. However, simply ignoring their portfolio’s fluctuations is often the hardest thing for investors to do.
  • Diversification: It’s an investment truism that combining asset classes with differing risk and return profiles will reduce overall portfolio volatility. Asset classes like bonds or cash can diversify a stock-heavy portfolio; however, they also typically offer lower returns than the long-term average of stocks. As usual, lower volatility typically means lower expected total returns.
  • Tactical shifts: You can attempt to limit your downside by tactically shifting funds from stocks into cash, bonds, or other asset classes, making multiple moves in your portfolio to increase or decrease your risk position. While you may participate in some losses, this strategy can help you avoid the bigger ones – but the trade-off is that you may not fully participate in a potential market rebound.
  • Alternative strategies: Alternative strategies include hedge funds and financial instruments, such as options strategies. Both seek to reduce exposure to large downturns, and both strategies are typically best implemented by investment professionals. While costs may be significant (and could potentially erode returns), these strategies can offer diversification and provide a “floor” for your portfolio value.

Each of these strategies comes with a trade-off. For some strategies, the trade-off is time – with time also comes the need to ignore daily fluctuations. Other strategies require higher costs, and some expose you to other risks, like liquidity or trading execution. The point is that there is no free lunch.

The key is to understand your expectations about gains and losses – would you be more upset to miss out on a raging bull market or see your portfolio lose a quarter of its value in just a couple months? It’s not enough to try to control risk: you also should know how you might react to large market swings – up or down – to gauge your comfort with uncertainty.

That’s where United Capital comes in. We will be empathetic to the broad range of emotions that can arise from the hot-button topic of money. Sometimes, the most important – and easiest – thing to do is nothing: watch the market gyrate while knowing you’re properly positioned to reach your goals. But that confidence will come after you’ve worked with an advisor to create a portfolio strategy that is best for you.

With confidence in your portfolio, you can shift your focus to what really matters in your life – which probably doesn’t include how the Dow Jones Industrial Average performed today.

This commentary contained herein is intended for informational purposes only and should not be construed as tax, legal or investment advice. Past performance is not indicative of future results. Clients should obtain their own tax, legal or investment advice based on their circumstances. The material is based on sources deemed reliable but is not guaranteed.

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