MarketWatch featured a story called “Point of no return,” which questions whether risk taking is worth the emotional cost for many investors.
Eight different types of risks are examined with the premise that there more of these are faced in a portfolio, the more diversified it is:
Let’s look at the types of risks mentioned:
1.Market risk is the big bugaboo, the chance that a downturn chews up your money.
2.Purchasing power risk, or “inflation risk,” is widely considered to be the “risk of avoiding risk” — the opposite end of the spectrum from market risk. It’s the possibility that you are too conservative and your money can’t grow fast enough to keep pace with inflation.
3. Interest-rate risk is a key factor in the current changing rate environment, where income may change drastically when a bond or CD matures and you need to reinvest the money. Goosing returns using higher-yielding, longer-term securities creates the potential to get stuck losing ground to inflation if the rate trend changes again.
4. Shortfall risk is about you, personally, more than it is the market, but it’s the chance that you won’t have enough money to make your goals. You can face shortfall risk by being either too conservative or too aggressive. The best way to address this risk is to save more.
5. Timing risk is another another highly personal factor, hinging on your personal time horizon. While experts agree that the chance that stocks will make money over the next two decades is high, the prospects for the next two years are murky, and if you need your money in two years, you should have concerns about your timing.
6. Liquidity risk has been the underlying issue in the mortgage and credit crunch, and it affects everything from junk bonds to foreign stocks. When the flow of money in credit markets changes for any extended period of time, holdings in those credit arenas tend to suffer.
7. Political risk is the prospect that government decisions will impact the value of your investments. In the current political environment, investors should worry about how the change at the White House may lead to new tax policies, which could trickle down directly into the pocketbook for investors. Tax-rule changes could make certain types of investments popular, and make others unattractive, and there’s always the potential to be caught somewhere in the middle.
8. Societal risk is ultra-big picture, looking at world events. This is what might happen in the event of terrorist attacks, war or catastrophe.
The theme of the story is is that “diversifying across the spectrum of risks — particularly pursuing investments that face different conditions so that their success or failure is not all tied to the same market characteristics — is widely considered the best way to build a portfolio that can be depended on in all circumstances.”
Sure diversification is an important part of any portfolio—up to a point. As recent market history has shown (as well as the last bear market), we are living in an era of instant communication and economic intertwinement where as a result a receding tide affects all ships. I have commented on that a year ago in “Where is the safe Haven,” as all asset classes took severe beatings.
Yes, diversification is important, but from my viewpoint it is not nearly as critical as having a defined entry and exit strategy designed to reduce volatility and protect a portfolio from severe downturns. Remember, most diversification attempts are based on a bullish (buy & hold) scenario, which can have severe consequences if the markets head the other way.