Every investment involves a certain amount of risk. The returns you hope to gain depend on the risks you're willing to take. There are two basic kinds of risk that matter to investing: market risk and inflation risk.
The first type and the one most investors understand best, is market risk. For example, when you invest in a single stock, the value of your investment depends entirely on its performance through the change in its market price and any dividend payments, which can vary due to many factors. Investing in a single stock, therefore, is inherently risky.
Trying to avoid market risk by choosing conservative investments, however, exposes your investments to the other kind of risk: inflation risk. Inflation drags down how much your retirement savings will eventually buy. If you invest too conservatively, your money may not earn enough to outpace inflation.
Reducing Market Risk
Both diversification and time work to reduce market risk. Mutual funds are an example of diversification. They reduce your market risk by purchasing a variety of investments in their defined category. Obviously, some funds invest more aggressively than others — and aggressive investing involves more market risk than conservative investing.
If you are diversified appropriately, another way to reduce market risk is through time. In fact, market risk is far greater in the short-term, approximately one to ten years. The longer you hold a diversified portfolio, the lower the market risk of that portfolio.
Reducing Inflation Risk
Conservative investment can expose a portfolio to inflation risk. This is because investments offering lower, steady returns — for example, money market, stable income, and bond funds — don't fluctuate much in price value. And, they rarely earn much more than the average rate of inflation. The problem with inflation risk is that you do not accumulate enough money to last throughout retirement. The only way to manage inflation risk is to accept some market risk, in the hope or earning higher returns. The key to long-term investing is to balance the two types of risk appropriately through asset allocation.
On the surface, asset allocation is a simple concept. By using asset allocation, a financial advisor aims to appropriately divide your investments among different asset classes such as stocks, bonds, and cash. That distribution is primarily based on your investment goals and the amount of risk you are willing to undertake when investing. The amount of risk you are willing to take should be based primarily on how much time you have until you need the money and how much money you currently have.
The details of asset allocation, however, can be mathematically complex. The analytical tools look at historical returns for different types of investments — cash, different types of bonds, and various types of stocks. From that data, they calculate the expected risk and the expected return for that particular type of investment. The risk is defined as the volatility of the returns for an investment. So if one investment returns 5.5% in year one, 5.3% in year two and 4.5% in year three, that would be far less risky than an investment that returns 53% in year one, -10% in year two and 24% in year three.
The expected risk and return for each investment type is then compared to that of every other investment type. Some will move in the same direction. Others will move in an opposite direction. The latter types provide the most benefit for diversification. In general, theory states that when you mix investment types that move in opposite directions, you can actually improve returns for any specified level of risk. So when one investment has gone down in value, you are holding others that may have gone up. Over time, you should be able to maximize returns for the risk you take.
The Efficient Frontier
All of this boils down to a curve on a graph, called the Efficient Frontier. The Efficient Frontier consists of a curve made up of points representing a number of portfolios with differing levels of risk and return. It is a curve that represents an optimal return for each level of risk. A portfolio positioned along the Efficient Frontier will yield greater returns than a portfolio of a similar degree of risk that does not fall along the Efficient Frontier.
An investor's goal over time should be to find an asset allocation that places them at some point on the Efficient Frontier; your preferred risk level determines which point. (As explained above, your risk level is based on how much time you have until you need the money and how much money you now have.) Some assets and asset classes may be able to outperform the Efficient Frontier in the short run. But in the long term, staying in a portfolio on the Efficient Frontier offers the most reliable way to get the best returns for a given level of risk.
GuidedChoice uses asset allocation to make recommendations for reaching your retirement goals. By determining your investment goals, the number of years you have to invest, your risk tolerance, and the availability of your financial resources, GuidedChoice is able to recommend the most appropriate point to position your portfolio on the Efficient Frontier.
If your portfolio moves away from its original asset allocation over time due to unequal gains or losses within different asset classes, you may face one of two scenarios: your exposure to risk could increase beyond your comfort level, or your future growth potential could decrease and negatively impact your investment goal. By rebalancing your portfolio on a regular basis, you ensure that your asset allocation remains fixed based on your stated goals regardless of market volatility. You can effectively rebalance your portfolio in any of three ways:
GuidedChoice monitors asset allocation exposure by using returns-based style analysis, and rebalances if any of the asset classes are outside of their target ranges. When rebalancing, asset classes will be brought back to their target weights. Rebalancing is invisible to participants, since the number of shares of the portfolio they own will not change.
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