by Gary Silverman, CFP®
Last week we looked at the three main types of investment risk you face. Today, let’s briefly look at how to protect yourself from them.
First, let’s protect against the loss of principal. Any company can go bankrupt, taking its stock and bond holders with it. The most common answer to this problem is to use short-term income securities like CDs; but stocks can also get involved here. While a single stock can most definitely go belly-up, what’s the chance of a basket of 20, 100, or 500 stocks all going bankrupt at the same time? Barring the core of the earth breaking apart, the chance is nil. The key is to have more than one or two eggs in your basket so that a couple of cracks won’t affect your lunch.
Then there’s the problem of purchasing power (inflation). Short-term government bonds and certificates of deposit offer little or no price volatility which protects your principal. However, over the long-term they have not been able to keep up with inflation, especially after taxes are deducted.
Bonds are a middle-ground, and a type exists that specifically adjusts to compensate for inflation. But if you want both protection against inflation and a decent amount of growth in your portfolio, the answer is stocks.
Stocks have, historically, provided the growth needed to overcome inflation and taxes. But their short-term volatility scares many investors. And as the markets have shown, “short-term” can last a decade. To get around that type of risk, you’ll need not just many eggs in your basket, you’ll need many baskets.
Now let’s protect you against volatility risk. While using a diversified mix of stocks can protect against principal risk, and the growth of stocks can protect you from purchasing power risk, volatility is their weak spot. Stocks are “bouncy” investments. And while a long-term investor can ride out the bounces, there is a way to calm things a bit.
That way is to diversify across asset types. No one investment protects against everything. So at our firm we use stocks and bonds, from large and small companies, U.S. and foreign based, both emerging and established, and add in real estate and commodities, using indexed and active investments, and also throwing in some hedging strategies.
You’ll also need some time, because with the exception of cash, any of those asset types can drop. And while it is just about impossible for all of them to do so at the same time, that impossibility happened in 2008. Even the perennial favorite of the masses, gold, was down in 2008.
This process of managing risk, diversifying investments and balancing portfolios is called “asset allocation.” It is, quite simply, the single most important part of the investment decision-making process. More on diversification in future columns.
This article was published in the Wichita Falls Times Record News on March 5 , 2017.
Gary Silverman, CFP® is the founder of Personal Money Planning, LLC, a Wichita Falls retirement planning and investment management firm and author of Real World Investing.