When we think of financial risk, we invariably think ‘market risk’ – the risk of losses due to the overall performance of financial markets. This includes stock market crashes, interest rate changes, and economic downturns. These risks impact you as they do everyone else.

When you scratch a little deeper you see that risk comes in all shapes and sizes, and this means you need a strategy to first identify your risk and then mitigate (alleviate, manage or diminish) the various risks you face.

You cannot avoid risk because taking risk is necessary to grow your wealth; and that’s because there’s no such thing as a guaranteed risk-free investment. That said, taking too much risk can get you into a load of financial trouble.

The million dollar questions then are: “What’s the appropriate amount of risk to take, and how do you keep a lid on the risks?” We get asked those questions quite often at WestStar.

Thankfully assessing and managing financial risk is one of the cornerstones of our approach to investing and financial planning.

Key Findings

In this blog article you’ll find:

• Managing financial risk can increase your odds of success.
• Start by assessing the risk within your portfolio.
• Assess your risk tolerance and risk capacity (your ability to deal with risk).
• Maintain a cash cushion to ride out short-term drops in your portfolio value.
• Ensure your investments are growing ahead of inflation. Proper diversification is the way to minimize the volatility within your portfolio.
• Make sure to balance your illiquid investments with liquid ones.
• Shorten the duration of your bonds to reduce the impact of inflation on your holdings.
• Expect the unexpected – be prepared financially for unforeseen events.

We know that managing financial risk can increase your odds of success and that there’s no better time than the present to assess both the risk within your portfolio and your ability to deal with it. After all, preparation always pays off, even if it’s just to ensure you have full confidence that you’re doing all you can to manage your risk.

Here’s How We Help You to Manage the Risks Your May Be Facing.

1. Know Your Risk Tolerance – One of our first steps when meeting with you is to assess your tolerance for risk. A short chat with some questions should establish how comfortable you are if and when your portfolio fluctuates in value.

Your risk tolerance is important because emotional and psychological factors can lead to poor investment decisions, such as panic selling during a market downturn, or holding onto a losing investment for too long due to overconfidence. Either way, rash decisions can have a devastating impact on your long-term success.

We spend the time upfront to clearly define your comfort level with market fluctuations. We discuss various market scenarios to get a feel for how different market conditions may play out (in real dollar amounts) within your portfolio.

2. Know Your Risk Capacity – Your capacity for taking risk is as important as your risk tolerance.  An investor with high risk tolerance may choose to be aggressive with their investments. If you don’t have that capacity, we work around this in targeting good returns.

Not everyone has that luxury. This is all about your numbers. We determine how long you plan to continue working, and factor in your earnings, investment values and the amount in your emergency fund. If these variables look favorable, you may be able to take on more risk.

3. Accept Shallow Risk – The temporary drop in some investments’ market prices happens all the time in the stock market. One stock may go up in price, while another may go down. Prices may drop by a large percentage and stay low for an extended period, but while this risk can be painful to experience, it is neither permanent nor fatal.

Shallow risk is inevitable and so we encourage our clients to maintain a sufficient cash cushion in their checking account to ride out any temporary drop in their portfolio value.

4. Avoid Deep Risk – “Deep risk” is a real loss of capital that can be devastating to manage. And it could be the result of factors like inflation, deflation, or confiscation.

At the moment, inflation is the only real concern for our clients, and our job is to ensure that their investments grow at a rate that outpaces inflation.

Inflation has receded, but the Fed has signaled it wants more positive data before pulling the trigger on reducing interest rates. Where tactics are concerned, we find that overweighting a diversified portfolio in equities -which have historically outpaced inflation – could help mitigate inflation risk.

5. Avoid Concentration Risk – This is the risk of loss when all your funds are allocated in too few investments. It is common for investors who get paid in their company stock. Over time, they accumulate so much that it makes up a dangerously large percentage of their portfolio. For others, stock concentration is an intentional choice. During the 11-year bull market, many investors dived deep into tech stocks, given their meteoric rise.

Implementing a proper diversification strategy means owning different types of investments in different industries, and is one way to minimize the volatility within your portfolio.

6. Avoid Liquidity Risk – This risk arises when an asset cannot be sold quickly enough in the market without affecting its price.

While it’s always helpful to have a cash cushion, in challenging times that may not be enough. We encourage our clients to make sure to balance their illiquid investments with liquid ones. Blue-chips stocks and high-quality bonds are excellent additions to any portfolio and offer the kind of liquidity that can be useful when necessary.

7. Avoid Credit Risk – Investments like bonds carry the risk that the issuing government or company will be unable to pay the interest or repay the principal at maturity.  The ratings of the bonds you own can help you evaluate credit risk. The highest credit rating of AAA represents bonds with the lowest credit risk. Bonds rated below BB+ are considered junk and carry the highest risk of default.

8. Reduce Interest Rate Risk – As the Fed raises interest rates, bonds tend to drop in value. Back in 2022, investment-grade bonds dropped double digits following aggressive rate hikes. Since bonds typically represent the “safe” part of an investor’s portfolio, when these drop in value it can sow seeds of doubt and fear.

We recommend that our clients shorten the duration of their bond holdings. Duration is the weighted average time until the bond’s fixed cash flows are received, and can be used as a measurement of interest rate risk – how much bond prices are likely to change when interest rates move. The shorter the duration of your bonds, the less impactful the change of interest rates will be on your bond holdings.

9. Plan for Time Horizon Risk – An unexpected life event, including job loss, disability, death or an unexpected expense may cause your investment time horizon to change.

Protecting against the risk of losing your job is not easy. You should look to having a robust cash reserve and being willing to radically cut expenses and modify your lifestyle to alleviate the financial challenges that come with the loss of your job

10. Plan for Longevity Risk – The major concern that many retirees face is outliving their nest egg. No one wants to find themselves needing to rely on family, friends or charity.

We don’t believe any of these suggestions will be easy, and they will require a coordinated and measured plan. However, their combined impact can help you to enjoy your retirement without having to worry about running out of funds. In this sense, the prize will be worth the pain.

In conclusion

Managing financial risk is crucial for protecting your portfolio and achieving long-term financial goals.  The process needs discipline and regular reviews, and most often involves diversification, staying informed, setting clear investment goals, and maintaining a disciplined approach to your investment strategy.

If you have questions about your specific circumstances, or want to talk about developing a financial plan to effectively address your goals and aspirations, please get in touch.

We welcome the opportunity to chat with you and wish you every success in the future.

Disclosures

A diversified portfolio does not assure a profit or protect against loss in a declining market.

All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.