There's an old investment adage that money managers toss around: "be risk diverse, not risk averse". But what does this intriguing concept really mean and why it is so important?
Risk is at the core of investing and is essential. You really cannot make any money without taking some risk, but excessive or irrational risks can be disastrous. Accordingly, there is nothing wrong being either risk friendly or risk averse. But there is something wrong with undiversified or mismanaged risk, or a portfolio that is so risk-free that it is also return-free.
The above adage is making a very specific point and one that is extremely important. Namely, if you are both willing and able to take more than an average level of risk, you must do so sensibly. Higher risk does not mean putting all your eggs in one basket or gambling. A good higher-risk portfolio will invariably still comprise various asset classes and can be managed actively and sensibly.
To some extent, you can be more risk friendly than you thought, provided it is really done correctly. Prudent risk friendliness does make sense. In other words, you should not shy away from risk per se, but away from too much or the wrong kind of risk.
Finding Your Level of Risk Tolerance
Certainly, you need a level of risk that you feel comfortable with in terms of your own personal risk tolerance. However, you should feel perfectly comfortable with a sensibly diversified and well-managed medium- or even high-risk portfolio, rather than leaving your money in the bank lying dormant for years.
There have even been cases of beneficiaries suing their trustees for leaving hundreds of thousands of dollars purely in cash or bonds for 30 years. If you compare the results of a well-diversified portfolio, it is shocking how poorly a truly low- or no-risk portfolio performs.
At the same time, trustees also get sued for portfolios that are almost totally in equities. Many naive investors thought their trustees or brokers were just wonderful until 2000 or 2008, after which all-equity portfolios came crashing down and the brokers were standing there like the emperor with no clothes.
In short, you do not want either of these extremes. You need something in the middle, or possibly a bit more risky than that, but only if it is well managed.
(For more, see What Is Risk Tolerance?)
Building a Sensibly Diversified Portfolio
You may want to have at least three asset classes and probably more. Equities, bonds and, say, real estate (plus cash) should be the minimum. And you can certainly extend this to private equity, foreign funds, hedge funds and so on, depending on the markets, your preferences and objectives.
You should not be trying to "time the market" precisely, but do keep an eye on all your asset classes — those you have now and those you may want in future. You will also want to ditch some and/or reduce your existing holdings from time-to-time. Managing your holdings is essential to optimizing your portfolio.
It is also important to at least set some limits, such as on exposure to U.S. equities, or to particular strategies.
For instance, you may want to have some value-based funds and some that are simple trackers. Similarly, some stop-loss procedures are often indispensable, particularly with higher risk assets, so as to avoid disastrous plunges in value.
You also need to know how your different strategies interact with each other and understand how good and bad investments mutate and evolve over time. The essence of the matter is to start with a sensibly diversified portfolio and to keep it sensibly diversified over time.
(Learn more in, Rebalance Your Portfolio to Stay on Track.)
Reevaluate Your Portfolio
It can be complicated, but it doesn't need to be. If you work with a good advisor or even on your own, you can keep it simple and still do well. You do not need excessive numbers of assets to diversify and active management does not have to be all that frequent.
A really active stock-picking process with masses of buying and selling can be a full-time job, and given the benefits, is often a fool-time job. For most investors, you and/or your broker just need to meet every few months (possibly monthly), or ad hoc if something changes suddenly. You can take a look at what you have, how it is doing and whether there are any danger signs with your current assets, or anything promising out there that you do not yet have. This is not a big deal and neither terribly stressful nor time-consuming.
But if you just leave your money stagnating in the bank or drifting up or down like a ship in the ocean, you are unlikely to do well. Furthermore, you won't reap the potential benefits of taking the right risks at the right time.
The Bottom Line
Tempting as it may be for cynics or those who really cannot be bothered with their money, just avoiding risk is not clever and not the answer. It is impossible to earn a decent rate of return over time on a portfolio that is too conservative. It will avoid losses in crashes, but also avoid profits in the good times. Remember, there are always good times and bad times for each type of asset class.
The real trick is to take the right risks in the right quantities at the right times. No one can get all of this spot on, but you do not need to do so in order to optimize your portfolio. You just need to have a sensible level of diversification, even at relatively high levels of risk, and be willing and able to both monitor the portfolio and take action when necessary.
(For more tips, see Risk and Diversification: Diversifying Your Portfolio.)