Best Risk Management Strategies For 2023

Investment risk refers to the potential for an investment to experience a loss or deviation from its expected return and can come from a variety of places. All investments carry some level of risk regardless of the sales story investors are often exposed to. Understanding and managing these risks can be difficult but is crucial to help investors make informed decisions and achieve their financial goals. Liquidity Risk The risk that an investment cannot be sold or converted into cash quickly enough at a reasonable price. For example, investing in less-traded or illiquid assets, such as certain real estate properties or thinly traded stocks, can expose investors to liquidity risk if they need to sell quickly during a market downturn. If liquidity is unavailable, investments often lose some of their value due to investor fear over being able to get their money back. Market Risk (Systematic Risk) Market risk is essentially the general market movements that can affect the entire financial system or a specific market segment. This is out of investors control, and affects all investments to some extent. For example, a sudden downturn in the stock market due to economic recession can cause the value of your investment to decrease. Interest Rate Risk The risk that changes in interest rates will impact the value of fixed-income securities. When interest rates rise, bond prices typically fall, and vice versa. For example, a bond investor faces interest rate risk when holding long-term bonds because if interest rates rise, it will reduce the value of existing bonds in the secondary market. Credit Risk (Default Risk) Refers to the possibility that a borrower or issuer of debt instruments may fail to make timely principal and interest payments.For example, companies may face financial difficulties and default on debt obligations, leading to losses for bondholders. Inflation Risk (Purchasing Power Risk) The risk that the purchasing power of an investment’s returns will decline over time due to inflation eroding the real value of money. For example, holding large amounts of cash can expose investors to inflation risk, as the returns may not keep pace with rising consumer prices. As seen in 2022, extreme inflationary environments do occur, and without preparation, your “safe” investments may actually be losing value. Political And Regulatory Risk Political and regulatory risk arises from changes in government policies, laws or regulations that can impact the business environment and affect investments. For example, if a country were to ban or impose stringent regulations on the use and trading of cryptocurrencies, it could lead to a significant decline in cryptocurrency values or limit the accessibility of crypto-related service. Currency Risk (Exchange Rate Risk) Currency risk arises from fluctuations in exchange rates, impacting the value of investments denominated in foreign currencies. For example, investing in foreign assets exposes investors to currency risk, as changes in exchange rates can affect the returns when converting profits back to the investor's home currency. Diversification is a fundamental principle in risk management, aimed at reducing the overall risk of an investment portfolio. By spreading investments across different assets, sectors and locations, investors can reduce individual risks and help investors achieve more stable returns. Several diversification strategies are commonly employed. Asset Allocation A risk management strategy that involves dividing the investment portfolio among different asset classes, such as stocks, bonds, cash and alternative investments. By allocating investments across various assets, investors can achieve a balance between risk and potential returns. For instance, in times of economic uncertainty, having a diversified asset allocation with a mix of equities and bonds can help mitigate the impact of a stock market downturn. Sector Selection Within each asset class, investors can further diversify by selecting various sectors. Different sectors perform differently based on economic conditions. For instance, tech stocks may outperform during a period of rapid technological advancements, while consumer staples may offer stability during economic downturns. By diversifying across sectors, you can reduce your exposure to the risks inherent in any single industry. Asset Location The placement of different investments in various types of accounts, such as tax-advantaged accounts (i.e. 401(k)s and IRAs) and taxable brokerage accounts. This strategy aims to maximize after-tax returns by considering the tax implications of each investment. For instance, tax-efficient assets, like index funds, may be held in taxable accounts, while tax-inefficient assets, like high-yield bonds, may be better suited for tax-advantaged accounts. Rebalancing One of the best risk management strategies is rebalancing, which involves regularly realigning the portfolio back to its original target allocation. As various assets perform differently over time, the portfolio's asset allocation may deviate from its initial balance. By employing rebalancing, investors can effectively maintain risk levels within their desired parameters and seize the opportunity to lock in gains from high-performing assets while capitalizing on opportunities in underperforming ones. Developing a quality risk management strategy requires expert guidance from a fiduciary adviser. The basic steps they can help you with will help safeguard your financial future. Below is a basic outline of the steps they may use: Having a well-defined process and disciplined approach to managing your investment portfolio is essential for achieving your financial goals. Regularly monitoring your portfolio's performance and periodically rebalancing its allocation are critical steps in maintaining your desired level of risk exposure. Over time, market fluctuations can cause an investor’s asset allocation to drift from its intended targets. By adhering to a systematic process and exercising discipline in rebalancing, you can effectively control risk and optimize returns while staying on track toward your financial objectives. Consistently monitoring and rebalancing your portfolio is a key aspect of successful risk management. This process ensures that your asset allocation remains aligned with your risk tolerance and long-term objectives. It involves evaluating the performance of your investments and making necessary adjustments to realign the portfolio as market conditions change. While some individual investors attempt to create and manage their investment process, seeking assistance from professional advisers can be highly beneficial. Advisers help investors avoid common pitfalls and behavioral biases associated with investing. By integrating disciplined monitoring and rebalancing into your investment strategy, guided by a knowledgeable adviser, you can maintain a resilient portfolio and enhance your likelihood of achieving financial success. What are some common investment risks that investors should be aware of? How can I mitigate investment risk? Some of the best ways to mitigate investment risk are diversifying your investments through asset allocation, sector selection, asset location and a disciplined process for rebalancing. For those seeking the ultimate method find a fiduciary adviser who can help coordinate all these risk management strategies alongside your financial plan and tax picture. Is it possible to eliminate investment risk entirely? No investment strategy can completely eliminate risk, as all investments inherently carry a degree of uncertainty. However, the primary objective for investors is to seek the optimal return relative to the level of risk they are willing to bear. It is crucial to factor in the investor's specific tax situation when evaluating the actual return on investments. Proper tax planning plays a pivotal role in maximizing after-tax returns, enabling investors to make well-informed decisions that align with their risk tolerance and financial objectives. By adopting a comprehensive approach that accounts for both risk management and tax considerations, investors can make better investment choices tailored to their individual circumstances, and increase the likelihood of achieving their financial goals.