Tahoe-Truckee Market Beat: Managing investment risk can be stressful
Managing your finances can be stressful at times. Stock and bond markets will go through cycles of volatility. Watching your long term investments decline in value can cause some headaches.
One of the keys to managing stress is understanding risk and knowing your own risk tolerance. Is your investment portfolio causing you some sleepless nights? Are you worried every time the stock market declines a little bit?
Investors are confronted by many different types of risk and how you decide to manage those risks can have a serious effect on your investment performance.
One way to define risk is that it’s the possibility of losing something. Many people think of investment risk in terms of experiencing a capital loss, buying a stock that drops and losing money. Remember Enron and World Com?
There’s also a risk in not investing which is known as purchasing power risk or inflation risk. If your long term investments don’t keep pace with inflation, you’ll lose purchasing power over time and effectively lose money because your dollars will buy less.
There’s a relationship between risk and reward; some risk must be assumed in order to enjoy decent long term investment gains. Investments in stocks are certain to go through short term periods of decline, even though over the long haul stocks have produced good returns.
According to data from NYU Stern the stock market has averaged over 11% per year for the last fifty years and just over 9% per year for the last ten years using the arithmetic average. If the numbers are calculated using the geometric average, the market has returned 9.61% over the last 50 years and 7.25% for the last 10 years. Using a geometric average is more realistic for investment returns because the annual returns are not independent of each other.
By comparison, 10-year US Treasury bonds have had an average return of 6.71% for 50 years and 4.71% over the last 10 years using a geometric average.
Risk can never be completely eliminated. If your investments are too conservative, you’ll protect your capital but can be exposed to inflation risk and lose buying power over time.
If your portfolio is too aggressive you could experience some capital losses. Diversification is one of the best tools for managing risk. It’s important to know your own risk tolerance and design a portfolio that you’re comfortable with.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.