Wealth management involves more than just making savvy investment decisions. It calls for a comprehensive understanding and application of effective risk management and asset allocation strategies. These critical elements are the bedrock of a solid investment plan.
What is risk management?
Risk management identifies, assesses, and addresses uncertainties that could adversely affect your financial objectives. As an investor, understanding that every investment comes with a degree of risk is pivotal.
Risk management aims to reduce the possibility of losses while staying focused on meeting financial goals.
Strategies for risk management
Risk can be managed in various ways, each with pros and cons.
At one extreme, risk can be largely avoided by investing in “low-risk” assets like bonds issued by the U.S. Treasury. If held to maturity, these bonds are guaranteed by the full faith and credit of the U.S. government, which has never defaulted.
Investors in Treasury bonds sacrifice the possibility of higher expected returns from stocks for the stability of lower interest rates on Treasury bonds.
Many investors need higher expected returns to reach their financial goals. These investors need to take more risk than investing in Treasury bonds. That’s where risk management becomes critical.
The role of diversification
Diversification refers to spreading your investments across different asset classes, like stocks, bonds, and real estate. The goal of diversification is to reduce risk by not putting all your eggs in one basket. By diversifying your investments, you can potentially minimize the impact of any one investment’s underperformance on your overall portfolio.
While diversification does not guarantee a profit or protect against losses, it can help manage risk.
The role of asset allocation
Asset allocation is the division of your portfolio between stocks, bonds, and cash.
Your financial goals, investment horizon, and risk tolerance should guide asset allocation. While stocks have higher expected returns than bonds, they are more volatile than bonds. A portfolio with a high allocation to stocks may experience stomach-churning ups and downs, especially in the short term.
Asset allocation strategies
There are a few common strategies for asset allocation used to manage risk. The main ones are strategic and tactical asset allocation.
Strategic asset allocation is a long-term investment strategy that involves setting target allocations across different asset classes and rebalancing regularly to keep the assigned asset allocation in place.
For example, you might determine that an appropriate asset allocation is 60% stocks and 40% bonds. If the stock portion of your portfolio goes up and now represents 70% of the value of your portfolio, you would sell enough stocks to return to the original 60/40 asset allocation.
Tactical asset allocation adjusts a portfolio based on short-term events to exploit perceived inefficiencies among asset classes. These shifts can be premised on market trends or economic conditions.
While the appeal of tactical asset allocation is understandable, according to research by Vanguard, “tactical allocation funds have generally posted lower median returns with greater return variation across managers than their counterparts with steadier strategic allocations.”
*Asset allocation does not ensure a profit or guarantee against loss; it is a tactic used to help manage risk.
Risk management is dynamic
Risk management in investing isn’t a “set it and forget it” process.
Investing involves inherent risks and uncertainties that can change over time. As a result, effective risk management requires ongoing monitoring and adjustments to adapt to evolving market conditions and new information.
Your goals, risk tolerance, and time horizons can evolve. Risk management strategies should be adjusted to align with your needs and objectives as these factors change.
The role of a financial advisor
A financial advisor plays a crucial role in risk management and asset allocation by guiding and assisting individuals or organizations in managing their financial goals and portfolios. Here’s how a financial advisor can add value:
- Risk Management: Financial advisors assess their client’s risk tolerance. They help clients understand and evaluate various investment risks associated with investing, like market volatility, inflation, interest rate fluctuations, and specific investment risks.
Based on this assessment, advisors develop risk management strategies. They may recommend diversification across different asset classes, investment products, and geographic regions to spread risks. Additionally, they can suggest risk management tools like insurance policies or hedging strategies to mitigate specific risks.
- Asset Allocation: A financial advisor helps clients determine a suitable asset allocation based on their financial objectives, risk tolerance, time horizon, and market conditions. Advisors create a customized asset allocation strategy by considering the client’s age, income, expenses, and investment goals. They review and adjust the asset allocation to align with the client’s changing circumstances and market dynamics.
- Portfolio Construction: Financial advisors assist clients in constructing investment portfolios that align with their risk profile and financial goals. They analyze and select investment options based on various factors, including investment objectives, risk-return characteristics, liquidity, and tax implications. They aim to build diversified portfolios that balance potential returns and risk exposure.
- Performance Monitoring: Financial advisors monitor the performance of their client’s investment portfolios. They track progress toward financial goals, evaluate the performance of individual investments, and compare them against relevant benchmarks. They may suggest asset allocation, investment strategy, or specific holdings changes to align the portfolio with the client’s objectives.
Risk management enables investors to make informed about their investments. It’s critical to helping to protect and grow your wealth.