Portfolio risk can be managed with effective diversification.
Most investors base their perception of risk on the fluctuating value of their monthly statements. For many, risk is really about, “how much can I lose in a short period of time?” Universally, investors want their investments to make them money – not lose it. Consequently, short-term declines can trigger an emotional and subjective response. These setbacks can also drive many investors into “safer” low-return investment options, or even to the sidelines. These investors may then miss out on early market recovery and the portfolio growth that comes with it.
The 2008 financial crisis left many investors reeling in the wake of profound losses to their portfolios. Investors have realized that recovering from an extreme decline in portfolio value can take time and will require a significant market gain to break even again. The chart below shows five pairs of figures. For each pair, the first figure (in blue) denotes the amount of loss and the second figure (in green) denotes the amount of gain needed to recover the loss. For example, if you lost 50% in the market, you would have to gain 100% to recover, which, at a lofty 9% annual rate of return, would take more than eight years.
Investors can win by losing less
In today’s volatile markets, preserving value by reducing exposure in negative periods and participating in positive markets is becoming increasingly important to many investors. Diversification is a key step towards managing downside risk. By investing in different investment styles, asset classes, regions and industry sectors, you can better manage risk by smoothing out returns. If all your investments rise and fall simultaneously, you have little protection from market volatility.
Diversification is really a simple strategy of not putting all your investments in one type of product or one part of the market. Because mutual funds hold a variety of investments, they provide instant diversification, which can minimize portfolio risk and volatility. For example, a balanced fund would hold a mix of stocks and bonds, based on the theory that stock and bond prices don’t often decline (or increase) in tandem. You can build diversification into your own portfolio of investments, but it takes time and expertise to research which investments are likely to best complement each other. With mutual funds, the research and monitoring are done for you. With an effective, actively managed portfolio, you can increase returns and reduce potential volatility in different market conditions over the long-term. While many investors think in terms of outperforming the market, real investment success is ultimately tied to avoiding, or at least minimizing, losses so you can keep more of your money working for you and growing over time.
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