This is the first in two posts on how avoiding investment disasters is no accident. It takes careful and thoughtful planning.
It’s true in life but is especially true in terms of investing: avoiding disasters is no accident.
When markets are up, indices are consistently setting new records, investor exuberance is high and risk management largely gets ignored as the lemmings chase ever-higher returns to their ultimate demise. But things that can’t go on forever won’t. Almost as soon as markets start to rise, corrections are on their way. When the party ends it usually catches many off-guard and is incredibly painful. This is not being pessimistic; it’s just not being ignorant of and refusing to acknowledge history.
Benjamin Graham, the “Dean of Wall Street” and the man Warren Buffet attributes teaching him all he knows about investing, said, “The essence of investment management is the management of risk, not the management of returns”. If this is true…and it is…then what’s the best approach for you?
The investment industry’s standard method of managing client portfolio risk is best exemplified by the widely used “60/40 portfolio”. Risk management is accomplished by holding 40-percent of the investment funds in bonds. Since bonds are favored in times of stock distress, this is meant to serve as a buffer to stocks during bear markets. This practice has become so standardized that it is commonly referred to as simply the “balanced portfolio”.
In fact, throw a dart at the mutual fund’s * page of the Sunday paper and you’ll probably find one of these funds. At best, if you’re with a traditional advisor, you may find a bevy of bond and equity mutual funds blended together in a format representing the same goal, managing risk by balancing bonds to equities.
This passive, fixed and unchanging style of risk management is called static risk management. But, does this static method provide the type of risk management most people desire? The answer is NO!
Static risk management supplies too little protection in bear markets and too much in the bull markets. In fact, a good analogy is to think of a static portfolio like an individual who dresses for all types of possible weather conditions but is actually ill-prepared for any specific condition… like someone wearing a ski parka and beanie cap while walking around in Bermuda shorts and flip-flops!
* Mutual Funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing in Mutual Funds. The prospectus, which contains this and other information about the investment company, can be obtained directly from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.