Successful investing requires discipline and patience. When emotions and investment volatility are running high, it can be easy to lose focus on your long-term investment strategy. One tool that can help you to overcome these challenges is a solid understanding of investment risks.
Do You Know the Risks?
Investors need to remember that markets can be turbulent and that preparing for potential declines is essential. There can be a strong temptation to pull out of markets when they become volatile.
At Sapient Investments, we have a proprietary risk management process by which we measure and control what we consider to be the four most important risks for investors:
- Equity market risk arises from the tendency of stock prices to move up or down together. Even bonds can be affected somewhat by equity market risk, especially corporate bonds, and particularly high-yield bonds. Credit risk is closely associated with equity market risk.
- Interest rate risk is the potential for investment losses resulting from a change in interest rates. If interest rates rise, the value of a bond or bond fund will decline. The longer the average maturity (mathematically measured by “duration"), the more pronounced this effect will be.
- Currency risk is sometimes referred to as “exchange rate risk” and arises from the change in the price of one currency in relation to another. Investors that have non-U.S. assets are exposed to currency risks that may create unpredictable profits and losses. However, some level of currency diversification can lower overall portfolio volatility.
- Commodity risk is the risk associated with changes in the prices of commodities. Because energy is such an important commodity in the global economy, most broad commodity funds are most heavily influenced by changes in the price of oil. Other commodities are related to agriculture, precious metals, and non-precious metals.
These four major risks do not typically rise and fall together. By spreading risk exposures among all four, investors can expect to lower their overall level of portfolio volatility. However, the relationships among the risk factors can change over time. For example, until recently, interest rate risk tended to have a negative correlation with equity market risk, which meant that bonds were excellent at diversifying stock market risk. However, thus far in 2022, stocks and bonds have both declined in price. During this period, the wisdom of having some commodity risk has been strongly demonstrated.
The dominant risk in nearly all portfolios is equity market risk. This is also the dominant source of long-term returns. The single most important decision that any investor must make is the level of equity market exposure to maintain in their overall portfolio. Typically, this is determined by the long-term return and risk objectives of the investor.
Leave Emotion at the Door
Stocks have always had, and probably always will have, a lot of volatility over short time periods. When markets swing, emotional decision making can wreak havoc on the most carefully designed investment strategies.
Without investment disciplines to guide you, fear and greed can drive your investment decisions. Fear can cause us to abandon an investment strategy when the outcome is not what we want, while greed can cause us to chase investment fads and assume too much risk. You can support your long-term strategy by attempting to subdue these emotionally-drive impulses.1 Reading up on the history of markets, including their frequent up and down cycles, can help mentally arm you for when you are experiencing market volatility yourself.
Research2 has shown that a trusted relationship with an investment advisor may be able to help prevent investors from making emotionally-driven mistakes. Ideally, this would be someone who is himself armed with extensive knowledge and experience, and who has the analytical tools necessary to make objective and sound investment decisions.
- “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha” (February 2019: https://advisors.vanguard.com/insights/article/IWE_ResPuttingAValueOnValue)
This content is developed from sources believed to be providing accurate information, and provided by Sapient Investments. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.