Managing Investment Risk
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Four Basic Strategies
Most folks can get reasonably comfortable with some level of risk and the ups and downs of market volatility by using four basic investment strategies:
- Focus on the long term
- Diversify your investments
- Invest regularly
- Keep in touch with your financial advisor
Focus on the long term. One key to living with market volatility is focusing on long-term results rather than the daily bumps along the way.
That can be especially difficult during prolonged market declines fed by daily injections of bad news. Investors living through the aftermath of the market bubble that burst in August 2008 were acutely aware of how challenging it can be to stay focused on the long term.
Diversify your investments. No one asset category does well all the time, so it can be a good idea to put your eggs in a variety of baskets. If some of your investments are down, others may be up.
One area of the market can be hot for several years, like large U.S. growth stocks in the second half of the 1990s. During those years, owners of diversified portfolios may not have had much to say when friends bragged about outsized returns in their 100% growth stock portfolios. But the market free fall that started in August 2008 underscored the value of diversification as a strategy for living with volatility’s downs.
Invest regularly. Also called dollar-cost averaging, an automatic investment program can be an excellent strategy for living with volatility’s downside and taking advantage of its upside.
You don’t need to worry about the best time to invest when you put away the same amount every month, but like most investing strategies, it doesn’t guarantee a profit or protect against loss in declining markets.
This strategy can help reduce anxiety about portfolio declines. The bright side of a down market is that you’re buying shares at bargain prices. However, this strategy requires you to continue investing through both the ups and downs. Before starting a dollar-cost averaging plan, consider your ability to continue buying shares through prolonged market and economic slumps.
Keep in touch with your financial advisor. Our last strategy for putting volatility in perspective may be the most important. Financial advisors are trained to focus on your financial goals, your time frame and your comfort with volatility.
Articles like this one can tell you what volatility is and provide some time-tested strategies for coping when investment values fall, but they can't meet your personal needs as effectively as a personal financial advisor.
Now let’s dig a little deeper into the three most powerful tools for managing risk: diversification, asset allocation and dollar-cost averaging.
What is Diversification?
Simply put, diversification means spreading your savings among multiple investments. It’s the financial version of the old adage “Don’t put all your eggs in one basket.” If your eggs are in one basket and that basket falls to the ground, you’re left with nothing but broken eggs.
Diversification is a little like insurance against a falling basket. By investing in multiple asset classes — equities, fixed-income, cash and commodities, to name a few — you can reduce the overall impact if performance from any one category is poor.
The benefits of diversification. Look no further than stock market returns over the last 25 years to see the benefits of diversification. If you bought just one stock in 1989, say it was IBM, you’d have had negative returns in only 8 years.
By contrast, if you’d invested in large-company stocks, as represented by the Standard & Poor’s 500 Index, you’d have experienced negative returns in only 5 years. While IBM is part of the S&P 500 Index, some of the index’s 499 other stocks were in positive territory while IBM was down.
Examples of diversification. In the following chart, the blue line represents IBM, a single stock. S&P 500 stocks are represented by the green line. A composite of 60% Stocks/40% Bonds is shown in the yellow intermittent line. Compare the difference in volatility between this one stock, many stocks, and a diversification (composite) of stocks and bonds in the chart below.
The 25-year annual total returns record may surprise you.
Diversification Can Help Reduce Volatility
25-Year Period ended December 31, 2013
Sources: International Business Machines Corporation, © 2014 Morningstar, S&P 500 Index, Barclays Capital U.S. Aggregate Index. Volatility chart traces annual returns for each of the following: one stock (IBM), 100% stocks (S&P 500 Index) and a combination of 60% stocks/40% bonds (60% of the S&P 500 Index and 40% of the Barclays Capital U.S. Aggregate Index). Indexes are unmanaged and one cannot invest directly in an index. This chart illustrates past results only and does not represent or predict the performance of any Franklin Templeton fund.
Different ways to diversify. You can diversify within an asset classes, across asset classes and even around the globe.
Diversifying within an asset class. By diversifying, you can help reduce the impact of a specific underperforming security. You could do this by purchasing many bonds, for example, instead of one or two.
However, there’s a limit to your diversification if all those bonds are municipal bonds from the state you live in. You can increase your portfolio’s diversification by owning different kinds of bonds — long term, short term, government, corporate, and possibly high yield.
Diversifying among asset classes. Diversifying can also help reduce the risk that an entire asset class, such as equities, will do poorly for an extended period of time. You can select investments from several asset classes — equities, fixed-income, cash and commodities, for example. This kind of diversification is also called asset allocation.
Diversifying around the globe. Diversification can also help reduce the impact if U.S. financial markets were to suffer an extended bear market. While global investing includes additional risks, such as currency fluctuations and political uncertainty, diversifying around the globe can help offset overall portfolio volatility.
Mutual funds — the easiest way to diversify. Most people simply don’t have enough money to invest in a broad array of individual equities, fixed-income and other assets, much less the time and energy to research and monitor them. For those investors, mutual funds may represent the most sensible option.
Mutual funds are diversified by definition. A single fund can hold securities from hundreds of issuers. Mutual funds provide an easy and cost-effective way to diversify within asset classes, across asset classes and around the globe.
Front-end, and in some cases back-end sales loads, management fees, Rule 12b-1 fees and other expenses are associated with Franklin Templeton mutual fund investments. Investment returns for a fund are reduced by these fees and expenses. Diversification does not guarantee a profit or protect against a loss.
Understanding Asset Allocation
Advocates of asset allocation believe that proper asset allocation is more important to long-term returns than specific investment choices. Understanding this strategy can be one of the keys to investment success.
Asset allocation means dedicating certain percentages of your holdings to broad asset classes like equities, fixed-income, commodities and cash as a way to achieve your financial goals while managing risk. Earlier, we called this approach diversifying among asset classes.
This strategy can work because different asset classes behave differently. Equities, for instance, offer potential for both growth and income, while fixed-income typically offers potential for stability and income. The benefits of different asset classes can be combined into a portfolio with a level of risk you can tolerate.
Although asset allocation plans will be different for different investors, a hypothetical asset allocation can be illustrated with a pie chart like the one below.
Hypothetical Portfolio Asset Allocation
Fundamentals of an asset allocation strategy. Market history tells us that asset classes perform differently from one year to the next. Fixed-income may post the best returns one year only to be outpaced by equities the next year. Or commodities may be the hot category for a while and then go flat as another category heats up.
Annual Total Returns of Key Asset Classes 1994-2013
Click for a larger view (PDF)
Source: © 2014 Morningstar. Large stocks are represented by the S&P 500; Large growth stocks are represented by the S&P 500/Barra Growth Index until 1995 and S&P Growth Index thereafter; Large value stocks are represented by the S&P 500/Barra Value Index until 1995 and S&P 500 Value Index thereafter; Small stocks are represented by the Russell 2000® Index; Small growth stocks are represented by the Russell 2000 Growth Index; Small value stocks are represented by the Russell 2000 Value Index; Foreign stocks are represented by the MSCI EAFE Index; and Bonds are represented by the Barclays U.S. Aggregate Bond Index. Indexes are unmanaged and one cannot invest directly in an index. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.
Diversification does not guarantee a profit or protect against loss.
It’s easy to see when looking at historical returns. However, predicting which asset class will do best in any given year is very difficult. For that reason, it can make sense to divide investments among asset classes to provide some exposure to the winning asset classes as they rotate over the long term.
Choosing the right asset allocation. Asset allocation helps investors balance the returns they want with an acceptable level of risk. Your asset allocation should be based on your investment goals, time frame and comfort and capacity for risk.
In retirement, you might want to emphasize fixed-income and cash for income and stability. But don’t overlook equities, because you need to keep up with inflation.
If you won’t need your money for 25 years, a financial advisor might recommend an asset allocation with a very high percentage of equities. That wouldn’t mean investing in only one stock. You’d still want your portfolio to be diversified across a variety of equities.
Once you’ve set your allocation percentages among asset classes, you can take asset allocation a step further by diversifying within the classes. For instance, your equities allocation might include a combination of large cap, small cap and global mutual funds. Keep in mind, however, diversification does not assure a profit nor protect against loss in declining markets.
A chance for more consistent long-term returns. When comparing different investment strategies over the past 20 years, investing across asset classes has helped reduce overall portfolio volatility, while helping to avoid market-timing pitfalls.
Consider the following three scenarios, illustrating different investing strategies. While these returns can’t guarantee future results, asset allocation, in this particular example, was the most successful strategy during the noted time period.
Does Asset Allocation Really Work?
Returns on $10,000 invested annually in equities and fixed-income
Source: © 2014 Morningstar. For illustrative purposes only. The returns shown reflect past results and do not predict or represent the performance of any Franklin Templeton fund. It is important to note than an asset allocation strategy does not ensure results superior to other investment strategies and also does not guarantee a profit or protect against a loss. Asset classes are represented by the following indexes: Large-cap stocks, S&P 500 Index; Large-cap growth stocks, S&P 500/Barra Growth Index until 1995 and the S&P Growth Index thereafter; large-cap value stocks, S&P 500/Barra Value Index until 1995 and the S&P 500 Value index thereafter; small-cap stocks, Russell 2000® Index; small-cap growth stocks, Russell 2000 Growth Index; small-cap value stocks, Russell 2000 Value Index; foreign stocks, MSCI EAFE Index; bonds, Barclays Capital U.S. Aggregate Index. Indexes are unmanaged, and one cannot invest in them directly. This illustration assumes that these indexes are reasonable representations of asset classes and their returns. However, investment manager performance relative to the different asset class indexes has varied widely during the past 20 years.
Asset allocation plans shouldn’t be set in stone. While an asset allocation plan eliminates a lot of the day-to-day decisions related to owning a portfolio of investments, it doesn’t eliminate the need to review your portfolio regularly with your financial advisor. Monitoring and rebalancing your asset allocation can help make sure you stay on track to meet your goals.
How Does Dollar-Cost Averaging Work?
A dollar-cost averaging strategy boils down to this: You invest a specific dollar amount at regular intervals regardless of the investment’s share price. With this approach you can opt out of the guessing game of trying to buy low and sell high.
By investing on a regular schedule, you can take advantage of market dips without worrying about when they’ll occur. Your money buys more shares when the price is low and fewer shares when the price is high, which can mean a lower average cost per share over time.
The most important element of dollar-cost averaging is commitment. How frequently you invest (monthly, quarterly or even annually) is less important than sticking to your investment schedule.
Dollar-cost averaging in a rising market. In the illustration below, $500 is invested in a mutual fund on the first of each month for 6 months. By dollar-cost averaging, an investor would spend $3,000 methodically acquiring 109.89 shares at an average cost of $27.30 each. When buying shares at specified intervals, there’s no guesswork or worry about what direction a share price may be moving.
|Purchase Date||Share Price||Shares Purchased|
For illustrative purposes only. Not intended to represent or predict the performance of any specific Franklin Templeton fund.
Dollar-cost averaging in a falling market. Now consider $500 monthly investments as the fund’s share price is falling. Dollar-cost averaging in this scenario reduced the loss, compared to a lump-sum investment. Six regular investments would have bought 98.63 shares at an average cost per share of $30.42.
The investment’s value at the end of the period in this particular scenario would be $2,564.38. By comparison, someone who invested the full amount in January at $38 per share would have owned only 78.95 shares, and the investment would have been worth only $2,052.70 at the end of the period.
|Purchase Date||Share Price||Shares Purchased|
For illustrative purposes only. Not intended to represent or predict the performance of any specific Franklin Templeton fund.
Dollar-cost averaging doesn’t guarantee a profit or eliminate risk, and it won’t protect you from a loss if you sell shares when the market is declining or at a low point. Before adopting this strategy, you should consider your ability to continue investing through periods of low price levels or changing economic conditions.
Avoiding minimum investment requirements. Dollar-cost averaging can provide a way to invest in mutual funds with high minimum investment requirements. Fund companies will often waive this requirement for investors who set up an automatic investment plan.
Smoothing out volatility. Dollar-cost averaging is also popular among those who invest in volatile funds. If a fund’s share price fluctuates frequently, dollar-cost averaging can help reduce the average cost per share over time.
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