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Managing risk is a crucial component of successful long-term investing. If we can effectively mitigate risk, we may have a better chance at staying invested through market’s ups and downs as well as achieving our long-term goals.
Here are four simple ways to mitigate risk that have been remarkably effective over time.
Many investors believe that if they intend to be invested for many years, they should only own stocks because stocks have historically had the best returns over time. But few investors can stick with a portfolio that is 100% in stocks over the long term because stocks are so volatile. We recently spoke with an investor who wanted to put all of her portfolio in stocks because, as she explained, she wasn’t going to need the money for a couple of decades. But when she learned about the frequency of market corrections --that the S&P 500 has averaged a 10% pull back every year and experienced a 20% sell-off about every 3 to 3.5 years -- our caller changed her mind. When she considered the emotional gut punch she might feel if her portfolio lost more than 20%, the potential buffer that bonds can provide started to sound appealing.
It can also be risky to keep too much of our portfolios in cash or bonds. Inflation erodes the purchasing power of cash over time, and bonds aren’t likely to generate enough return for most of us to achieve our long-term goals.
A mix of stocks and bonds, however, has the potential to participate in market rallies and buffer market declines. In the Autumn 2014 Upgrader (click here to read), we looked back at a portfolio that was invested 60% in stocks (as measured by the S&P 500) and 40% in bonds (as measured by the Barclays Aggregate Bond index) over every 10-year period from 1925 through 2013, and found that the balanced portfolio had higher average returns than a portfolio that was 100% bonds and it lost less in market downturns than a portfolio that was 100% stocks.
A client once came to us with a retirement portfolio that was entirely invested in Bank of America stock. He didn’t think this was particularly risky since Bank of America is the second largest bank in the country. But even the most well-established companies can experience major sell-offs and even bankruptcies. Lehman Brothers had been in business for over 100 years before it filed for bankruptcy in 2008. Enron was one of the world’s leading energy companies before it was undone by an accounting scandal. Enron stock lost 99% of its value in 2001.
Owning a diversified portfolio of stocks can help mitigate the risk that any one stock declines dramatically. If we owned 10 stocks, and two of those stocks went down to zero, our portfolio would decline by 20%. But if we owned 100 stocks and two of those stocks went to zero, our portfolio would decline just 2%.
Mutual funds offer additional diversification since most of us can own more stocks through a mutual fund than we would on our own. With S&P 500 index fund, for example, we can own 500 stocks in one fund purchase. And we can further diversify by owning a portfolio of funds.
The built-in diversification of mutual funds can also help stem losses. If a single position in a diversified mutual fund files for bankruptcy, it’s unlikely to have a major impact on the fund as a whole. While investors who owned Enron lost almost their entire investment in 2001, investors who had exposure to Enron through diversified funds lost far less, and investors who owned a portfolio of funds lost even less.
Different funds have different risks. Some stock funds are broadly diversified and subject to market-level risk, while others are concentrated in a single sector and may have above-average risk. Bond funds also have different risks: lower-quality bond funds, for example, are more susceptible to credit risk, while longer-term bond funds have more interest-rate risk.
Some investors opt to avoid riskier funds altogether, but these funds have the potential to add tremendous value at times, and investors who exclude these funds from their portfolios risk missing out on good returns.
We use riskier funds but we limit exposure to these funds and use them as part of a well-constructed fund portfolio. In the Flexible Income Fund (INCMX), we can invest in lower-quality bond funds, but we cap exposure to these funds. In the Upgrader Fund (FUNDX), we limit exposure to stock funds that invest in a single sector. We also diversify our exposure among leading sector funds and pair these funds with a core allocation to broadly diversified funds.
Markets change over time, and a fund that does well in one market environment may not continue to do well in the next. If we don’t adapt to these changes, we risk holding on to lagging funds indefinitely and missing out on the chance to buy into new market leaders.
In the tech boom in the late 1990s and early 2000s, it often seemed like tech would continue to be the best place for growth. But markets changed, and tech suffered extreme losses. The tech-heavy NASDAQ Composite index is still trading below its March 2000 all-time high 14 years later. Some investors rode tech all the way down, while other investors moved on to better performing areas of the market.
How can we avoid getting stuck holding lagging investments? One solution is to rely on an active investment strategy. Our Upgrading approach can take action when markets change. It has a clear sell signal that leads us to replace a position if it isn’t adding value. In 2014, it led us to replace small- and mid-cap funds in most of the equity Upgrader Funds. These funds had been strong performers in 2013, but in 2014, they faltered and we moved on to better-performing large-cap funds. Large-caps brought in double-digit returns in 2014, while small-caps had meager returns.
The S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general. The Barclays Aggregate Bond Index is an unmanaged index generally representative of intermediate-term government bonds, investment grade corporate debt securities and mortgage-backed securities. The Nasdaq Composite Index is market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange. You cannot invest directly in an index.
Diversification does not assure a profit or protect against loss in a declining market.