What’s the best way to manage risk in my portfolio?
Using a variety of indicators, we can measure different types of risk for all types of investments.
The measure of how much risk is involved in producing a portfolio return is called a “risk adjusted return.” Using a variety of indicators, we can measure different types of risk for all types of investments. Bonds, equities, mutual funds, ETFs and alternative investments all have risk ratings. It’s how we put these asset classes together that determines your risk adjusted return.
By diversifying, or spreading your investments over a number of asset classes, you may reduce the risk of fluctuations attributed to any single investment. Studies have shown that 93 percent of a portfolio’s return can be attributable to asset allocation. That means only seven percent of the portfolio return is security selection. By doing the proper due diligence on each investment, analyzing the risk ratings and properly monitoring the asset allocation, a diversified portfolio can produce superior risk adjusted returns.
The best way to approach diversification is to work with your advisor to establish objectives and goals for your portfolio by creating an investment policy statement. Once this has been done, you should determine the allocation of fixed income, equities, alternatives and cash. The blend of these asset classes is more macro in nature and tends to look at which presents opportunities and challenges.
In the bond market, the Federal Reserve’s taper talk has been front-page news. But determining the best “value” in the treasury market has not been easy. Analyzing corporate bonds, international bond exposure, mortgage-backed securities and high-yield bonds are all strategic considerations.
The domestic equity markets have outperformed recent forecasts. With corporate profitability and the housing market strengthening, combined with the outlook that the global financial crisis is improving, the allocation to equities needs to be monitored closely. Alternative investments continue to provide risk management in the way of less volatile return streams. Alternative strategies can lead to uncorrelated returns and portfolio diversification. In our opinion, when domestic equity markets are strong, this “risk management” technique may reduce portfolio returns. But in more uncertain times, alternatives may provide steady returns with less market correlation.
As you can see, managing risk is a highly complex process. But with ongoing oversight from experienced professionals, you’ll be able to better formulate a plan to balance the risk versus reward in your portfolio.