Tackling the Task of Managing Risk in a Way That Suits You Best

Patrick McFadden, CFP®, CIMA® CPM® | January 6th, 2023

A Generic Discussion for Evolving Your Investment Policy

When it comes to managing investment risk, which is easier; confidently investing your serious money for the next six years or the next six months?

It's a trick question, as there is no comparison. In the same way that healthcare experts discuss achieving better outcomes by following specific steps and practices, one can also achieve better investment outcomes by compartmentalizing and managing risks – and ignoring what you can't control.

Defining Financial Risk Management:

Financial risk management, or simply put, separating a blind risk from taking a calculated risk, is essential for adequately evaluating and mitigating potential financial losses. It involves understanding the various investment risks and developing strategies to manage them. A comprehensive financial risk management plan should include a detailed assessment of an investor's portfolio, including asset allocation, diversification, portfolio rebalancing, and stress testing. This helps investors identify and understand their overall risk exposure across different asset classes and economic conditions.

Overview of Long and Short-Term Financial Risk Strategies:

Taking on risk can be beneficial. For short-term investors with a high risk tolerance, investment strategies may be limited to a few options, such as stock trading and day trading. In contrast, long-term investors have more choices and decisions, including diversifying their portfolio, actively managing trades, and monitoring market conditions.

Long-term investments typically involve detailed strategic planning that encompasses asset/liability matching, rebalancing, and goal setting; for retirement planning, college education funding, estate planning, and tax minimization.

Benefits of Implementing Risk Management Strategies:

While many risks are associated with investing in long- and short-term strategies, there can be significant rewards when risk management strategies are correctly implemented. Risk management may help investors protect their capital from the impact of taxes and inflation. Having a comprehensive plan also allows investors to stay disciplined even during volatile markets and uncertain economic conditions. Implementing a successful risk management strategy involves creating an investment plan based on individual goals and objectives and assessing risk levels and time frames. Once in place, monitoring is necessary for rebalancing and new trends that can inform future decisions. By following these steps, investors can help ensure they take advantage of potential opportunities while minimizing potential losses from market volatility over the short and long term.

Short-Term Risk Management Strategies

Budgeting & Cash Flow Forecasting

In terms of short-term risk management strategies, investors can use asset/liability matching and rebalancing to great effect. Cash flow forecasting is important as it allows investors to predict their future liquidity in an emergency or unexpected expense. Investors should maintain a 'safety net' in the form of a cash cushion depending on specific circumstances to ensure that they are prepared if such an event arises.

Additionally, liquidity planning should also be considered, as having access to ready cash reserves can protect against market volatility or unforeseen circumstances. When developing a liquidity plan, it is essential to consider all potential income and savings sources along with the potential impact that withdrawing funds could have on the long-term financial plan. With this approach, investors may balance their need for liquidity with their desire for higher returns over time.

Market Risk Monitoring:

Regularly monitoring market risk is essential to protect investments and maintain portfolio health. Markets are constantly changing, so it's essential to be aware of market trends, factors, and influences that can affect the performance of investments. While never a guarantee, investors can better assess risk and ensure their portfolios are well-positioned for future success by analyzing past performance and understanding current market conditions. This analysis should include an evaluation of the macroeconomic environment, industry-specific trends, stock valuations, technical indicators, news releases from corporations and governments, and other vital data points. Additionally, investors should consider utilizing financial advisors or investment experts with credentials, experience, and knowledge that is outside of one's own core competencies, to help identify opportunities for risk management within their portfolios.

Hedging

Hedging strategies involve using financial instruments to reduce investment risk. These instruments can protect against fluctuations in asset prices or currency exchange rates. When implementing hedging strategies, it is important to understand the associated costs and weigh them against potential losses. Tailored strategies should be crafted to fit each investor's needs and goals.

Diversification

Generally, diversification can be a successful strategy because it allows investors to spread their risk among multiple asset classes and securities, reducing the potential for significant losses in case one or more particular security or sector performs poorly. When diversifying investments, it is important to remember that different asset classes tend to be correlated with each other – positively or negatively – in different market cycles. Therefore, over-diversification can lead to reduced returns as correlations emerge and reduce the utility of diversification.

A successful diversification strategy involves selecting assets that are not perfectly correlated with each other but still enable an investor to create a portfolio that provides adequate exposure to their chosen asset class or sectors while at the same time mitigating over-concentrating risk and volatility. Moreover, when building a diversified portfolio, investors need to establish suitable benchmarks against which they can measure their performance over time so that adjustments can be made if needed.

Long-Term Risk Management Strategies

As investors look to the future, they need to have a comprehensive risk management strategy in place. This involves measuring and monitoring results against selected risk-adjusted benchmarks over different periods. Such measures should include asset/liability matching, rebalancing, and strategic planning for retirement, college education, estate planning, and tax minimization.

Long-term risk management strategies are particularly important in light of the significant impact of Federal Reserve policy, inflation, and interest rate trends- currently not seen in decades. Investors must become more proactive to potentially achieve consistently positive returns going forward, as market conditions are ever-changing and performance no longer comes from every direction. Therefore, investors must monitor the 'household' of assets within the investment policy on an ongoing basis and not take a 'set it and forget it' approach, as this can lead to muddled outcomes over time.

To ensure long-term success, investors must be cognizant of their financial goals and capacity for risk-taking when developing their investment plans. Diversification is key in reducing potential losses from unexpected events or stock market declines; however, there is no guarantee of performance across all sectors or strategies at any given time. Therefore, investors must be mindful of how each asset affects their overall portfolio and make necessary adjustments accordingly.

Investing regularly helps mitigate two significant contributors to portfolio volatility: timing risk (being caught out if markets decline) and sequence risk (not being able to recover losses quickly enough). Lastly, focusing on cost-cutting solutions and tax-efficient investments may help maximize returns while keeping costs low over time.

Having a comprehensive financial risk management strategy is fundamental to meeting long-term objectives such as retirement security or maintaining wealth for future generations. Monitoring results against selected benchmarks across various periods will help investors stay ahead of ever-changing market conditions. Armed with greater knowledge about how different assets affect overall performance, along with sound cost-cutting solutions and tax-efficient investments, will best help enable investors to realize their desired outcomes over time.

Final Thoughts

By thoughtfully implementing strategies, planning for retirement and college education, estate planning, and tax minimization, investors can be better equipped with the necessary tools to help maximize their returns without taking on unnecessary much risk. Furthermore, investors can optimize their portfolio strategies for better overall outcomes by considering all aspects of portfolio construction, including asset allocation based on an individual's goals and objectives and tax implications associated with various investments.

At the end of the day, any form of investing involves some risk; however, it is possible to manage this risk through careful planning and making knowledgeable decisions. By implementing a comprehensive financial risk management strategy tailored specifically for each investor's unique circumstances, individuals are more likely to realize their desired long-term objectives with fewer negative surprises along the way.

For more help with answers to your specific concerns, we can be reached by contacting us:

By email: patrick.mcfadden@opco.com

On LinkedIn: https://www.linkedin.com/in/pkmcfadden/

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DISCLOSURES

The opinions expressed herein are solely those of Patrick K. McFadden and are subject to change without notice. The information set forth herein has been derived from sources believed to be reliable but is not guaranteed as to accuracy and does not purport to be a complete analysis of market segments or strategies discussed. Investing in securities is speculative and entails risk, including potential loss of principal. The opinions of the author expressed herein are subject to change without notice and do not necessarily reflect those of the Firm. Additional information is available upon request.