Risk Management
Risk management has two dimensions: assuming the proper amount of market risk and diversifying adequately. It is well understood that riskier assets provide higher expected returns than safe assets. As compensation for investing in an asset that can lose substantial value in any given year, you expect a higher return over time. Because some investors have too short an investment horizon to recover from loss, it is vitally important that you assume the proper amount of risk. Taking on too much risk may result in your assets being unavailable when they are needed; taking on too little risk may result in inadequate growth over time.
The second dimension of risk management is diversification. Diversification is achieved by including in your portfolio assets whose prices tend not to move together over time. The benefits of diversification can best be shown through an example. Suppose that there are three hypothetical assets: A, B, and C. Assets A and B are unique investments, and C is a portfolio, rebalanced annually, that is invested half each in assets A and B. The returns for the investments are shown below:
| |
A |
B |
C (50% A, 50% B) |
| Year 1 |
40% |
-20% |
10% |
| Year 2 |
10% |
10% |
10% |
| Year 3 |
-20% |
40% |
10% |
|
At the end of the third year, a $100,000 investment in either A or B grows to $123,200, but a $100,000 investment in Portfolio C grows to $133,100. The extra gain of Portfolio C is due entirely to diversification's risk reducing properties.
In your equity portfolio we diversify broadly to take advantage of the powerful benefit of diversification. We include large and small domestic stocks, large and small international stocks, emerging market stocks, real estate, and commodities. Further, each of the stock "asset classes" is represted by an asset that typically includes hundreds of stocks. This level of diversification is unachievable by most individual investors investing in individual stocks.
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