Managing Investment Risks in Your Portfolio

Investment risks, or the chance that your investments could potentially lose value or fail to achieve an important financial goal, is a reality for every investor. Charting the road to meeting your financial goals means managing investment risk in your portfolio.

For most investors, this is as basic as having an appropriate asset allocation and diversifying investments within each asset class (stocks, bonds and money markets). For experienced investors and mutual fund managers, trying to manage investment risk is more complex, sometimes relying on financial instruments to try and minimize risk.

Who needs to manage investment risk? Every investor
The idea of implementing effective risk management strategies can seem intimidating at first, particularly if you're a novice investor. The principles, however, are simple enough for anyone to understand. Don't assume that you don't need to worry about investment risk because you own shares of a mutual fund. Mutual funds carry the same types of risks as any other investment, and they can lose value over time.

Managing investment risk begins with a focus on your most important investment priorities, such as identifying financial goals, understanding your own tolerance for investment risk and selecting a mix of investments that's appropriate for your unique needs.

Types of investment risk
The types of risk you face as an investor should directly influence your risk management initiatives. Depending on the types of investments you choose, you'll face one or more of the following risks:

• Loss of value. While you invest money in the hope of watching your portfolio grow in value over time, you must also accept the fact that those investments could become less valuable instead. That's known as the risk of loss. Although some less-than-reputable investment firms may promise "guaranteed returns," it is virtually impossible to completely remove the risk of loss when investing in stocks, bonds or mutual funds. Even a low-risk investment can lose money, and pursuing a higher rate of return means taking on a higher level of risk.
• Portfolio drift. This risk arises when your portfolio (or a professionally managed mutual fund portfolio) ceases to address its original investment goals. Sometimes this can happen intentionally, such as when a large-cap mutual fund manager decides to start buying stocks of smaller companies in an effort to boost his fund's returns. Portfolio drift can also happen naturally if some investments gain value at a faster pace than others, thereby throwing the overall asset allocation out of balance.
• Asset redundancy. Owning redundant investments, such as two or more mutual funds with very similar investment objectives or portfolio holdings, can be a waste of money as well as time. Owning redundant investments forces you to pay several sets of fees instead of just one, and it also requires you to spend more time monitoring and managing all of those accounts. You also wind up concentrating your risk in a narrow sector of the overall market, which will cause the value of your portfolio to decline if that sector falters.
• Playing it too safe. Investing exclusively in ultra-conservative fixed-income investments such as money market funds may seem like a good idea when the stock market is bouncing up and down on a daily basis, but it may not be a wise long-term strategy. If you need to grow the value of your assets significantly over the course of many years, it may be appropriate to invest at least a portion of your assets in stocks or stock mutual funds. Conservative investments, although potentially less volatile, don't offer enough growth to protect your assets from the buying power that's lost each year to inflation.
• Underperformance. For some investors, generating positive returns isn't good enough. They also feel the need to outperform their peers or the overall market by generating higher returns than anyone else. This type of portfolio risk is unlikely to influence the thinking of most individual investors, but it can be a powerful motivator in the world of professional finance and mutual funds, where prestige is often measured in terms of portfolio outperformance. A fund manager determined to deliver the best performance may be more likely to make high-risk moves.

Best practices for investment risk management
As an individual investor, your two most important risk management priorities should be to determine an appropriate asset allocation for your portfolio and to diversify your assets to try and minimize the risk of loss.

Your asset allocation is your big-picture investment strategy; a general overview of the types of investments you own, often expressed in percentage terms. For example, if you invest exclusively in stocks, your asset allocation is 100% stocks. If you own an equal mix of stocks and bonds, your asset allocation is 50% stocks and 50% bonds.

Your asset allocation should complement your personal financial goals, including your time frame, risk tolerance and overall financial needs. As a rule of thumb, the higher your investment risk tolerance and the longer your investment time frame, the more stocks you may want to include in your portfolio. Stocks will bounce around in value over the short term, but over time they have historically provided the highest rate of return to investors, though past performance is no guarantee of future results.

Diversification is an essential portfolio risk management strategy that reflects the age-old wisdom, "Don't put all your eggs in one basket." By investing in a well-diversified mix of potentially complementary securities, you could minimize your overall portfolio risk. Gains from some investments might offset losses incurred by other investments.

Be careful not to go too overboard with diversification. Some investors spread out so thin that they essentially hold the market, a tactic that is much more easily achieved with investments in a handful of index funds.