How can we successfully manage investment risk? Consider applying the principles of risk management discussed in our article entitled “Four Ways to Manage Risk.”
Avoiding Investment Risk
We should completely avoid high severity risks that are likely to occur, such as the risk of losing all of our money through gambling or investing in penny stocks. If you feel compelled to gamble for entertainment purposes, just be sure to do so only with however much you would be willing to flush down the toilet. Don’t make it your retirement savings strategy. I am opposed to gambling even for entertainment, though, because it can be very addictive and destructive, and it goes completely against the principles of wise stewardship.
Reducing Investment Risk
We can reduce investment risk through diversification, which means that we do not put all of our eggs in one basket. Many people who think they are well-diversified really are not. For example, I have met several people who think they are very well-diversified because all of their investments are in U.S. large-cap growth stock mutual funds with a variety of fund families. Typically they are shocked when I point out that most of these funds are actually investing in the same 100 or so stocks, and that many of these stocks are very similar to each other in nature. Sure, they are more diversified than if they were investing all in one stock, but true diversification would include a much larger variety of characteristics, such as geographic areas, sizes of companies, growth stages of companies, types of products or services provided (i.e. financial services, health care, technology, consumer goods), and types of investments (i.e. stocks, bonds, cash, real estate, commodities, precious metals, options, absolute return funds), to name a few.
Transferring Investment Risk
For the amount of money we cannot afford to lose, we may want to transfer investment risk to large, financially stable institutions, such as profitable banks or insurance companies. How much can we not afford to lose? This would include our emergency fund of three to six months of living expenses, as well as whatever investments we plan to rely on during retirement to cover at least our basic expenses, especially if we are getting close to retirement age.
We can transfer investment risk to a bank through CDs or money market accounts, or to an insurance company through annuities or whole life insurance. CDs pay a guaranteed fixed interest rate for a specified period of time, regardless of the bank’s investment performance. Money market accounts pay a variable interest rate, adjustable by the bank from time to time, but with no risk of losing principal when FDIC-insured.
Fixed annuities pay a guaranteed fixed interest rate for a specified period of time, much like a CD, regardless of the insurance company’s investment performance. Variable annuities allow participation in market growth opportunities while minimizing downside risk by guaranteeing a certain amount of retirement income for life, regardless of market performance.
Whole life insurance provides guaranteed cash value and a guaranteed death benefit, regardless of the insurance company’s investment performance. It can grow by more than the guaranteed amount if the insurance company does well, but it is not subject to market risk. A significant portion of the cash value may be withdrawn tax-free at any time for retirement income or other purposes, and in some states may be protected from creditors.[i]
Retaining Investment Risk
For the amount of money we are willing to risk losing, we may choose to retain risk by investing on our own to see if we can produce higher returns than financial institutions can guarantee for us. Of course we would still be prudent to reduce risk of losing these assets through adequate due diligence and diversification. It is also wise to invest primarily in that which we understand or over which we have some control. For example, although starting a small business is normally considered a very risky investment, it may not be as risky for someone with 20 years of successful experience working for a large corporation before starting her own business in the same field.
[i] We do not provide tax or legal advice. Please consult the appropriate advisor for more information regarding your specific situation. Policy benefits are reduced by a loan, loan interest and/or withdrawals. Dividends, if any, are affected by policy loans and loan interest. Withdrawals above what is paid into the policy may cause ordinary income taxes to be paid on the gain portion of the policy. If the policy lapses, any withdrawals or loans considered gain in the policy may be subject to ordinary income taxes. If the policy is a Modified Endowment Contract (MEC), there are no loans and any distribution is considered a withdrawal. These withdrawals are distributed as gain first and subject to ordinary income taxes. If the insured is under 59 1/2 the gain portion of the withdrawal is subject to a 10% tax penalty.
Adam Dawson, CFP® is a Principal at Capstone Capital and the author of Timeless Principles of Financial Security.
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