What’s your risk tolerance?
It’s a standard question in investment management, and you might have a very clear answer. But whatever your risk tolerance, you’re probably taking on a lot more than you realize — and that additional risk is almost certainly costing you.
Don’t let your psychology get in the way of your investment plans.
Here are three commonly overlooked sources of portfolio risk and how to fix them:
1) Lack of Diversification
Whether it’s because you’re holding onto a lot of company stock or because you just picked a few mutual funds, chances are your portfolio is too heavily concentrated in a few investments. That means you’re under-diversified, and a lack of diversification is a major source of investment risk.
Even without company stock, a lot of people don’t realize how concentrated their portfolios really are. After all, you might think, with five or six mutual funds, and thus all the stocks that come with each one, how can someone be under-diversified?
But your portfolio might be heavily concentrated in one or two markets or asset classes. How much of your portfolio is exposed to the S&P 500? To the U.S. stock market? It’s probably a significant amount.
Far from being the safer option, concentrating your portfolio is adding risk to your account by over-exposing you to the movements of just a few markets. This is why diversification is so powerful.
By spreading the risk to different industries, sectors or geographies, a diversified portfolio reduces the potential downside of each one, while still giving you the chance to enjoy growth.
How to mitigate this risk:
For basic equity diversification, focus first on incorporating several different geographies and company sizes into your portfolio.
For example, you might split your holdings between the U.S., Europe, Asia and other emerging markets.
You might also target small, medium and large companies. This will give you exposure to an enormous amount of opportunities around the world — without over-exposing your portfolio to any single one of them.
2) Too Much Trading
You probably don’t think of trading as a risk, but it is.
Trading fees are dangerous because they don’t usually appear as a line item in your account balance and because they strike most people as too small to make a difference. But trading can really make a difference: one study found that very active traders take up to a 6% annual performance penalty every year, on average.
Add any sales loads to your mutual fund trades, and it starts getting very costly very quickly.
So, how do you know if you’re trading too much? It’s difficult to say, of course, and it depends on the account. Some say once a year is plenty. Others point out that to truly minimize trading costs, you might want to rebalance only when your actual allocations are way out of line with your target allocation — some say 5% – 10%.
This can get complicated if you enjoy picking stocks. In that situation, you might find yourself going in and out of positions as you get new information or change your preferences.
Unfortunately, this kind of trading is the most dangerous of all: by accumulating trading fees through your active style, you’re necessarily dampening any performance gains you might have otherwise enjoyed. Over time, you could end up shooting yourself — and your financial future — in the foot.
How to mitigate this risk:
Stopping yourself from making active trades can be extremely difficult, especially if you enjoy it.
One way to limit the downside is to introduce separate accounts for your trading activities. Decide how much you can afford to “spend” on speculation or risk-taking, and open a separate account to do it in. This places some necessary barriers on the activity and also allows the rest of your money to grow undisturbed.
Separate accounts, in other words, give you the benefit of both approaches: you still get to do what you want (and more easily track your performance), and you still get the long-term appreciation that comes with leaving your larger pot of money alone.
It’s a win-win that can significantly reduce the overall risks facing your portfolio.
3) Emotional Investing
Similar to over-trading, emotional investing brings a lot of unseen risk into our investment decisions.
It’s unfortunately the case that few people (if any) have the kind of killer instinct that makes instinctual investing a viable strategy. Most of the time, emotions actually get in the way when we invest. We sell when markets go down because we get scared, buy hot stocks because we see them in the press and get excited and so on.
And it’s not just us — even the pros succumb to their emotions. Just look back at the frenzy for internet stocks during the dot-com boom or the overheated housing market in the 2000s.
By letting feelings like fear and greed direct our actions, we also let them cloud our judgment. This is normal: we are human, after all. But that doesn’t mean you should let your portfolio suffer as a result.
How to mitigate this risk:
A lot of investors benefit from having a financial advisor to provide a steadying hand in both boom times and busts.
It’s not just for portfolio allocation and strategy: it’s for the kind of emotional support that can help you stick with your long-term strategy and avoid hasty (and costly) decisions. In short, a good financial advisor will be there to help you understand what’s going on in the markets and how to get through it.
So, if you find yourself struggling to keep up or feel pulled in a thousand directions when it comes to your investing strategy, you might want to consider getting help. You can seek out someone to do a simple review of your portfolio or even to take comprehensive control of your investments: whatever your preferences and comfort level, there’s help out there for you.
All of these investing mistakes amount, generally speaking, to human error. We often don’t see how much risk we end up adding into our lives when it comes to investing, but the more you become aware of your own behavior and how to work with it, the quicker you can move towards investing success.
