Want to get better at investing? Are you looking for simple, approachable ways to deepen your knowledge of the keys that create financial success? Using academic research and expert advice, this resource offers twelve principles for building wise, sustainable wealth.
Principle 5: Intelligently Manage Market Risk
Wise diversification means low-cost exposure to a range of capital markets from around the world, as opposed to simply investing in many different accounts or securities. Diversification also allows investors to more successfully cope with two kinds of investment risks: avoidable concentrated risks and unavoidable market risks.
Lightning Bolts vs. Rain Storms
Concentrated risks are like lightning strikes that damage specific stocks, bonds or sectors. For example, when an individual company goes through a sudden downturn for whatever reason, stock prices also drop causing investors to feel the pressure. This can occur even when the rest of the market is thriving.
Most economists consider concentrated risks to be largely avoidable. Investors inevitably experience occasional losses, but the impact of those losses can be significantly mitigated if your holdings are spread across global markets. It’s easy to see how diversification buffers concentrated risks: even if some of your returns are negatively affected, your other, stronger holdings effectively neutralize any serious damage.
Market risks are the great equalizers – the rain showers that fall on everyone the same. These risks affect a large percentage of the market; anyone invested in capital markets faces them. You can hide your cash under the mattress and know for sure it won’t go anywhere. (It may be worth less due to inflation, but that’s a different conversation.) The moment you invest in the market, you’re subject to market risk. It’s unavoidable.
The Expected Rewards of Risk
Yet again we see the benefit of group intelligence. Fortunately, the market as a whole knows the distinctions between risks you can avoid and those you can’t. This collective wisdom can guide us in how to intelligently manage our own investing using an evidence-based plan.
- Concentrated Risks
Focusing on specific types of stocks or sectors in an attempt to beat the market leaves you exposed to higher concentrated risks. Investors using this strategy should not expect to see consistently high returns over the long term. Diversification, on the other hand, helps you steer clear of these risks.
- Market Risks
Market risk can never be completely eliminated, even in well-diversified portfolios. Investors who hold steady even when risk goes up can expect to see higher returns as compensation for their tenacity. In the short-term, however, there is always the possibility that results may not meet expectations. Because of this, it’s important that investors think carefully about taking on the right amount of personal financial risk. Diversification becomes a useful tool for gauging the appropriate amount of market-risk exposure for your portfolio.
The Bottom Line
Determine your ideal combination of concentrated risks and market risks. Achieve enough diversification to minimize risk exposure and maximize expected returns.
McLean Asset Management Corporation (MAMC) is a SEC registered investment adviser. The content of this publication reflects the views of McLean Asset Management Corporation (MAMC) and sources deemed by MAMC to be reliable. There are many different interpretations of investment statistics and many different ideas about how to best use them. Past performance is not indicative of future performance. The information provided is for educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy or sell securities. There are no warranties, expressed or implied, as to accuracy, completeness, or results obtained from any information on this presentation. Indexes are not available for direct investment. All investments involve risk.
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