Risk management is a prominent aspect of portfolio analysis, and yet it remains frustratingly difficult to grasp. It's not just a question of differing opinions on the best way to control risk - the very definition of risk varies from one expert to another.
In an issue of the Financial Analysts Journal (FAJ), David M. Blanchett and Philip U. Straehl point out that defining risk according to the composition of an investment portfolio may be too narrow a focus. An investment portfolio exists in a larger context of personal wealth, and you should take that context into account in the construction of your portfolio.
As discussed in the FAJ article "No Portfolio is an Island," the following are three of the bigger picture factors that should inform portfolio construction.
The size and reliability of your income should be a consideration in how you construct your investment portfolio. A counter-intuitive aspect of this is that even though you are likely to earn less money in the early years of your career, the income of younger people is generally a bigger factor in total wealth than the income of older people. This is simply because younger people have typically not accumulated as much wealth in other assets.
A $35,000 income to a 24-year-old with no assets (beyond $500 in a savings account) is a more significant component of financial well-being than the $75,000 income of a 50-year-old who has built up a $600,000 retirement portfolio. Therefore, the risk profile of your investments typically becomes a more significant consideration as you get older.
Another way that employment weighs on overall financial risk is how you make your money. Two people may make the same income, but there is a big difference if one is in a very volatile industry while the other is in a highly secure position such as that of a tenured teacher. In that scenario, the person with the more uncertain income might be well served to have a more conservative investment portfolio than the person with the more secure position.
Your profession also matters in terms of the industry composition of your portfolio. An auto worker might want to be more cautious about a heavy weighting of car company stocks than someone in an unrelated industry. This is because those holdings would essentially represent doubling up on exposure to the auto industry. This is important because employees sometimes tend to be attracted to stock in their own company or industry. However, from a risk-management standpoint, they should be avoiding such holdings.
Owning a home should also be taken into account in portfolio construction because in many cases, that home is a person's single biggest asset.
One aspect to consider is that two people may own homes with similar values, but the weighting of those homes in terms of their total wealth depends on how far along they are in paying off their mortgages. Essentially, as you pay down your mortgage loan, your house becomes a bigger part of your overall wealth. Thus, your portfolio should increasingly be thought of in terms of comprising complementary assets.
The role of home value is also impacted by the volatility of your local housing market. If you live in a market subject to wild price swings, you may want to have a less risky investment portfolio than someone in a more stable market.
Finally, vesting towards retirement entitlements should also play a role in how you view risk management. This can be another source of counter-intuitive risk management tactics. One typically thinks of decreasing portfolio risk as one gets older. But, if you view vesting towards Social Security as building up an income-producing asset, other holdings logically can afford to get more rather than less risky.
On a related note, it also depends on whether you are in a retirement plan that entitles you to a specified income, as in the case of a defined benefit plan. Or you have one that is based on the accumulation of assets, as is the case with defined contribution plans such as 401(k) retirement savings. The latter scenario calls for less risk in other investment assets than the former.
As closely as financial risk is studied, there will never be a precise way to measure or even define that risk. Why? Because central to the nature of risk is that it is unpredictable. Still, elusive though an exact mastery of risk may be, examining its characteristics and manifestations can help you prepare for at least some of the possibilities. Additionally, you will be guarding against one of the greatest financial risks of all: complacency.
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