All investments carry some degree of risk, which is the possibility of incurring a loss. Typically, as investment risk increases, so do returns, as investors desire higher returns to compensate for taking on more risk. We will examine how to balance your investment portfolio to achieve the desired returns while minimizing risk as much as possible.
Recognizing Investment Risk
Investment risk can result from a variety of factors, including:
1. When you purchase a company’s stock, you are essentially purchasing a portion of the company. When you purchase a company’s bond, you are essentially lending the company money. You seek a return on your investment in either dividends, capital appreciation, or interest payments. However, in order to obtain this return, the company must remain solvent.
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When a business collapses and declares bankruptcy, its assets are liquidated. The preferred shareholders receive any funds after the bondholders. Common shareholders are the last in line, and they may receive nothing. As I explained in a previous article, if you purchase an annuity, there is a danger that the company will not last long enough to pay you for the remainder of your life.
2. Volatility risk: It is possible to purchase a stock whose price chart indicates it is on an upward trajectory, only to see its price abruptly drop. This decline may be due to a number of factors, including company-internal issues, the release of a defective product, negative press, or political or market events. Shares of fast food chain Chipotle Mexican Grill (CMG) fell by 21% in 2016 in response to reports of E. coli and noroviruses in its restaurants.
3. Inflation reduces the purchasing power of an investment’s distributions or interest payments, eroding their value. The dollar experienced an average inflation rate of 4.5% per year between 2019 and the present, amounting to a cumulative price increase of 19.3%.
4. Interest rate risk: The bond market is especially sensitive to variations in interest rates. If you hold a bond until its maturity date and then sell it, you will receive the face value plus any accrued interest. If you sell a bond prior to its maturity date, it will sell for either more than its face value (at a premium) or less than its face value (at a discount), as rising interest rates make newly-issued bonds more appealing to investors.
5. Liquidity risk occurs when an investor is unable to transfer their stocks, bonds, or other investments. This concern was addressed for exchange-traded funds with minimal assets under management (AUM) or daily trading volumes. Liquidity is also an issue for investments such as certificates of deposit (CDs) that impose a penalty for early withdrawals.
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With inflation at 3.0%, dividend stocks are one of the most effective methods to combat inflation and generate a reliable income stream. Download Five Dividend Stocks To Beat Inflation, an exclusive report by John Dobosz, Forbes’ dividend expert.
Diversification Techniques
Diversification is the process of constructing a portfolio from assets with varying rates of return and risk levels. If you only owned shares of companies in the oil and gas sector and the price of gas dropped, you may have suffered a loss. However, if you also owned shares of companies in the consumer staples sector, they may not have been affected by the change in the price of oil.
The following are the most effective portfolio diversification strategies:
1. Determine correlation: If all of your investments rise or fall in lockstep, this indicates that they are correlated. For instance, high-yield bonds are frequently correlated with stocks, so a portfolio consisting solely of these two categories of investments would not be sufficiently diversified.
2. Diversify across asset classes. A diversified portfolio must include at least two asset classes, such as equities, bonds, commodities, real estate, or Treasury bills or notes.
3. Diversify your investments geographically; holding investments from a single country can leave you vulnerable. For instance, Israeli equities are currently suffering due to political turmoil in Israel. You can diversify your U.S.-based holdings with “ex-U.S.” exchange-traded funds, such as the Vanguard Total International Stock ETF (VXUS) and the iShares MSCI ACWI ex-U.S. ETF (ACWIX).
4. Diversification within asset classes: For equities, consider diversification within the eleven Global Industry Classification Standard (GICS) sectors: energy, materials, industrials, utilities, healthcare, financials, consumer discretionary, consumer staples, information technology, communication services, and real estate. Bonds should be diversified by including corporate, Treasury, and municipal bonds from multiple issuers, and their maturities should be staggered. If you are a holder of funds, ensure that they are invested in diverse sectors or regions.
5. Consider alternative investments, such as commodities such as gold, silver, cereals, natural gas, and crude oil, or real estate investment trusts (REITs), which do not correlate closely with stocks. Real estate investment trusts own or manage properties such as office buildings, apartment complexes, retail centers, and hotels.
Monitoring And Adjusting
It is essential to closely monitor and periodically rebalance your portfolio in response to market forces, market volatility, or personal events. These events may include unanticipated medical expenses, property repairs, or looming education costs. Changing the portfolio’s weightings is another term for rebalancing. At least once a year, you should rebalance your portfolio.
Any rebalancing will create new risk and reward opportunities. Your investment horizon has a significant effect on risk. Typically, long-term investors have time horizons of at least 30 years. Moderate-term investors have horizons of approximately 20 years, whereas short-term investors have horizons of less than 20 years. The optimal portfolio for short-term investors or those with a low-risk tolerance would consist of 50% bonds and 50% equities.
When rebalancing your portfolio, keep in mind that purchasing and selling investments can incur transaction costs as well as tax implications. One of these factors is whether your capital gains are subject to short-term or long-term tax rates. Depending on your marginal income tax rate in 2022, the long-term capital gains tax rate will be either 0%, 15%, or 20%.
When purchasing investments, it is essential to maintain a record of the number of shares or units purchased, their individual pricing, and the total transaction cost. Attempt to maintain a constant total of the value of your portfolio’s investments. This metric allows you to evaluate the performance of your portfolio from year to year.
With inflation at 3.0%, dividend stocks are one of the most effective methods to combat inflation and generate a reliable income stream. Download Five Dividend Stocks To Beat Inflation, an exclusive report by John Dobosz, Forbes’ dividend expert.
Risk Management Instruments And Methods
These are some of the instruments you can use to reduce risk:
1. Stop-loss orders: You can place a stop-loss order with your broker or investing platform, which will automatically sell an investment if its price falls below a predetermined threshold. For instance, if you purchased a share of stock at $100 per share, you could place a stop-loss order at $90 per share in the event that the share price continued to decline.
2. Hedging strategies: Hedging entails having a position that offsets an existing one. The offsetting position may consist of a related security or a derivative security. Options, futures, swaps, and forward contracts whose fundamental assets are stocks, bonds, currencies, commodities, or indexes constitute derivatives. Losses on one side of a hedge may be offset by gains on the other side, but it is essential to note that hedging reduces returns while reducing risk.
3. Options trading is fundamentally a game of three guesses: which direction the price of a stock will move, how far up or down it will move, and when this movement will occur. A call option is a contract that grants the buyer the right to purchase a specified stock at a specified price, known as the strike price, and within a specified time frame. You are not required to purchase the stock, however.
A put option grants you the right to sell shares of a stock at a specified price and within a specified time frame. Similar to call options, put options do not require you to sell the underlying stock. If you believe the price of a stock will rise, you should acquire a call option and sell a put option. If you believe a stock’s price will decline, you should purchase a put option and sell a call option.
FAQs About Portfolio Allocation
What is asset allocation?
Portfolio allocation is the process of constructing an investment portfolio with various asset classes, such as stocks, bonds, currencies, commodities, and real estate, to maximize returns and mitigate risk.
What differentiates traditional portfolio theory from modern portfolio theory?
Traditional portfolio theory advocates diversification across asset classes, whereas contemporary portfolio theory advocates diversification across individual securities.
What is the optimal strategy for asset allocation?
The optimal asset allocation strategy for an investor depends on his or her financial objectives, risk tolerance, and investment horizon. Before deciding on an allocation strategy, investors should evaluate their individual circumstances.
What is the tactical allocation of assets?
The investment strategy of tactical asset allocation adjusts the portfolio’s asset allocation to capitalize on short-term market trends and opportunities.
What is the dynamic allocation of assets?
Dynamic asset allocation is an investment strategy that rebalances a portfolio based on market conditions, the investor’s financial objectives, and risk tolerance.
How do I select the most suitable asset allocation tool?
The appropriate asset allocation instrument will depend on the investor’s requirements, level of expertise, and budget. Before selecting one, investors should conduct research and compare a variety of instruments.
With inflation at 3.0%, dividend stocks are one of the most effective methods to combat inflation and generate a reliable income stream. Download Five Dividend Stocks To Beat Inflation, an exclusive report by John Dobosz, Forbes’ dividend expert.
Conclusion
Investment risk is a significant factor in determining the value of an investment portfolio. It can result from factors such as stock price fluctuations, liquidity risk, inflation, interest rate risk, liquidity risk, and the ability to transfer stocks, bonds, or other investments.
To minimize risk, investors should recognize investment risk, diversify their portfolio, determine correlation, diversify across asset classes, diversify geographically, and consider alternative investments.
Monitoring and adjusting the portfolio is crucial, as it creates new risk and reward opportunities. Rebalancing the portfolio is essential to address market forces, volatility, or personal events.
Long-term investors have time horizons of at least 30 years, while moderate-term investors have horizons of approximately 20 years. Short-term investors should have a portfolio consisting of 50% bonds and 50% equities.
Risk management instruments and methods include stop-loss orders, hedging strategies, and stop-loss orders. These instruments automatically sell investments if their price falls below a predetermined threshold, and they can offset existing positions with related security or derivative security options, futures, swaps, and forward contracts.
By balancing investment portfolios, investors can achieve desired returns while minimizing risk. Hedging in options trading involves guessing the direction, price, and time of a stock’s movement.
Call options grant the buyer the right to purchase a specified stock at a specified price and within a specified time frame, while put options allow the buyer to sell shares at a specified price and within a specified time frame. Asset allocation is the process of creating an investment portfolio with various asset classes to maximize returns and mitigate risk.
Traditional portfolio theory advocates diversification across asset classes, while modern portfolio theory advocates diversification across individual securities. The optimal asset allocation strategy depends on an investor’s financial objectives, risk tolerance, and investment horizon.
Tactical asset allocation adjusts portfolio allocation to capitalize on short-term market trends and opportunities, while dynamic asset allocation rebalances a portfolio based on market conditions, financial objectives, and risk tolerance.
Selecting the most suitable asset allocation tool depends on the investor’s requirements, expertise, and budget. Dividend stocks are an effective method to combat inflation and generate a reliable income stream.
