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A Smarter Approach to Risk

By Peter McDougall

Volatility and uncertainty may be the new norm for global markets, but there are strategies investors can use to address risk.

The global markets are plagued by uncertainty. From the European debt crisis to the slowing of the once–white–hot Chinese economy, investors have had to contend with significant ups and downs in the financial markets in recent years. And many affluent investors have decided that the markets’ unpredictable movements are too much to stomach

But while it may be tempting to stop investing, such a strategy carries significant long–term risks, according to John Sawyer, chief investment officer at BBVA Compass. “It’s very easy to choose when to get out of the market, but it’s extremely difficult to know when to get back in,” says Sawyer.

Instead of eliminating risk by avoiding the stock and bond markets, investors should consider constructing an investment portfolio that is better tailored to their personal risk tolerance and time horizon. “By establishing those guardrails and managing risk, investors are less likely to move into the avoidance phase during a down market,” says Sawyer.

Build from the ground up. Addressing risk through portfolio construction begins with a simple question: How much pain can you take? The answer is different for each investor and involves identifying how much you can comfortably afford to lose if faced with a prolonged market downturn.

This assessment begins with a thoughtful discussion with your financial advisor, covering how much of your portfolio you can afford to lose, but also discussing how you react to risk. Does having a portion of your savings tied up in the stock market keep you awake at night? Are you worried about your portfolio when you read bad news about the stock market?

Meanwhile, consider your long–term financial goals €”whether saving for retirement, paying for a child’s education or leaving a financial legacy for the next generation. Your investments will play a key role in generating the growth necessary to reach those goals.

These discussions can help as you and your advisor determine an appropriate asset allocation €”the mixture of stocks, bonds and cash investments in your portfolio. For instance, if you want to limit the volatility in your portfolio, you need to reduce your exposure to stocks, which carry the greatest risk of short–term losses compared to bonds and cash investments. “Your pain threshold will dictate how much of your portfolio is invested in equities,” says Sawyer.

Time matters. As you build your asset allocation strategy, also consider how much time you have to save. The longer your time horizon, the more latitude you have to ride out short–term dips in the market. Uncertainty in the markets can cause significant short–term volatility, but has much less impact over longer periods. Part of your discussion with your advisor involves making sure you are focused on an appropriate time frame, which can give you the confidence to ignore the daily rise or fall of your portfolio’s value

The asset allocation strategy you choose is not set in stone. Remember to periodically review the makeup of your portfolio and make adjustments if necessary. Sawyer suggests annual checkups to make sure your asset allocation still reflects your risk tolerance. For instance, a major life event such as a new child may lead you to reevaluate how much of your portfolio you can afford to lose.

There is plenty of uncertainty in today’s markets, but there are also plenty of opportunities. The key, says Sawyer, is to make sure your portfolio can take advantage of those opportunities without taking on too much risk. With the right combination of stocks, bonds, and cash investments, Sawyer says investors can be better prepared to handle whatever the market sends their way. “By taking a deliberate approach to risk, you’ll have greater trust in the process and will be less likely to panic,” he says.

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