The Less Risky Portfolio

When it comes to investing, risk is not a dirty word. Indeed, taking on risk is essential to building wealth, since the rewards of a riskier investment are often, but of course not always, larger than those found in relatively lower-yielding securities like US Treasuries or triple-AAA-rated bonds.

“Risk is good. Not properly managing your risk is a dangerous leap.”—Evil Kenevil

When it comes to investing, risk is not a dirty word. Indeed, taking on risk is essential to building wealth, since the rewards of a riskier investment are often, but of course not always, larger than those found in relatively lower-yielding securities like US Treasuries or triple-AAA-rated bonds.

Of course, you should not take on more risk than you and your financial planner deem necessary to help meet your financial goals. The current market in particular, in which volatility reigns supreme, calls for a diversified portfolio. A well-chosen mix of asset classes can help reduce much of the turbulence.

The bad news is that most physician-investors ignore this simple principle—until their portfolios have large fluctuations. Most everyone’s making money in a good market. But in the current market, it’s important to know your risk.

Knowing the importance of diversification, a well-meaning investor might buy a selection of stocks—airlines, healthcare, retail, etc.—figuring that this is a sufficient hedge against one or two of them posting low returns or losses. However, this is flawed thinking. True diversification means owning securities across not only a variety of industries, but also across assets classes (for example, stocks, bonds, and commodities). The idea: Each can react differently to the same economic event.

For example, a major California earthquake might deal a blow to that state’s utility bonds, but it would most likely not affect Coca-Cola.

Diversification reduces bumps in the road. While diversification does not eliminate risk, does not guarantee a profitable investment return, and does not guarantee against a loss, it is a method used to manage investment risk. The ingredients for a healthier portfolio include:

Stocks—specifically small-cap, midcap, and large-cap stocks from a variety of industries—should form a major part of your mix. While smaller companies may offer great growth opportunities, they can also be more volatile and risky — a tendency counterbalanced by large-cap stock holdings. Investing across various sectors helps hedge against industry-wide problems. Keep in mind that stocks have fluctuating principal and returns based on changing market conditions.

Bonds, the “airbags in your portfolio,” often move in the opposite direction of interest rates. Inherently more stable than stocks in terms of value, their yield can be predictable. Bonds have fixed principal value and yield if held to maturity. However, bonds have inflation, credit, and interest rate risk. Prices of fixed income securities may fluctuate due to interest rate changes, and investors may lose money if bonds are sold before maturity.

Commodities, such as gold, oil, and copper, move differently from both stocks and bonds. Consider them yet another way to diversity your portfolio.

Real estate is a very important piece in any portfolio. Most people should look for real estate outside their home state. Likewise, buying two homes in Arizona or any other state is not diversification—particularly now, when an increase in property value is hardly a given. Broaden the scope of real estate investments to include, for example, good opportunities in commercial and industrial real estate, and also undeveloped land.

Mutual funds by themselves are not an automatic means of diversity. Yes, it’s true that mutual funds comprise numerous stocks. But most funds provide a singular focus (for instance, utility stocks or Asian stocks). This means that the entire fund may be affected by an adverse occurrence in one industry or area. It’s always best to assess the companies within a mutual fund to see how they fit in your overall portfolio plan.

Private equity and hedge funds are available only to accredited investors with high risk tolerance and commensurate assets, though there’s something to be said for their niche nature. Steep fees and a lack of direct Securities and Exchange Commission regulation diminish their appeal. Many funds also use leverage to enhance returns potential; this strategy works in a bull market, but it can sink fast and deep in bad times.

Limits to Diversification

Of course, you can also spread investments too thin. After a certain point, even using a diversification investment strategy levels off, and you’re left with more investments to track and more fees to pay if you’re in a mutual or hedge fund. If you maintain 20 to 40 different assets in your portfolio, consider it adequately diversified.

Diversification through an asset allocation strategy is a useful technique that can help reduce overall portfolio risk and volatility. Diversification neither ensures a profit nor protects against a loss. Diversification offers returns that are not directly related over time and is intended for the structure of a whole portfolio to help reduce the risk inherent in a particular security.

Talk With Your Financial Planner About:

• Diversifying your portfolio with your investment goals, risk tolerance, and time horizon in mind

• Moving a concentrated stock position into other assets and industries

• Structuring an overall financial plan that lessens a portfolio’s risk exposure as you near retirement

Mr. Lowry, "The Business Owner's Advisor," has 25 years of experience specializing in advising and serving physician businesses. His fee-based financial planning and investment advisory practice is affiliated with Sagemark Consulting, a division of Lincoln Financial Advisors, a registered investment advisor. He helps doctors accumulate and transfer wealth in tax efficient ways through unique strategies that support their personal goals and family values. He welcomes questions or comments at russell.lowry@lfg.com or 888-921-8455.

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