No Pain, No Gain

Incorporating and Managing Risk in Your Investment Portfolio

By Kara Stefan

“Most women have been taught–implicitly or explicitly–to put any savings at all in the bank. This often leads us to be overly cautious when it comes to taking risks,” writes Marlene Jupiter, in her book Savvy Investing for Women: Strategies from a Self-Made Wall Street Millionaire.

Just like most of life’s important decisions, the more willing you are to put yourself out there in terms of risk, the more you stand to gain. And lose. But with life, career, and finances, the key to hedging risk and gaining the best odds is education.

“An educated investor–much like a seasoned gambler who knows the rules of the game–is thus equipped to decide how she should stack the chips on each wager,” advises Jupiter. She emphasizes the importance of thoroughly understanding both the downside and upside to each investment before making any decision.

Time
Nowhere is it more true that “time is on your side” than when it comes to investing. Debra Dawson of San Diego has always been cautious about investing money she inherited from her parents, but in recent years, she’s used a portion of her portfolio to take advantage of the booming stock market of the ’90s.

“I decided I would dollar cost average into some riskier investments through my IRA,” says Dawson. “That way I can spread out that risk over the next 20 years.”

She takes a three-fold strategy:

First, she uses the dollar cost averaging technique to invest small amounts of money over time–ensuring she doesn’t plunk down a lump sum when prices are high.

Second, she chose two mutual funds–which are inherently diversified. She researched and selected an overseas fund and a biotech fund. “Ultimately, I went with mutual funds because I’m not going to be actively monitoring these stocks,” Dawson explains. “I’d rather pay some professional who does this for a living.”

And third, she wrapped the mutual funds within an IRA account, to take advantage of long-term tax-deferred compounding. This is particularly important since her fund choices offer generous upside potential. In years where her funds may rack up spectacular returns, she won’t have to pay capital gains taxes.

“I figure, if you’re going to take on more risk, be prepared to wait longer for a return on your money,” observes Dawson.

Diversification
Take a test to see how well diversified your portfolio is by logging onto www.RiskGrades.com. There you may enter your entire investment portfolio–you simply need to know the stock symbols and how many shares you own in each investment. The risk evaluation tool will give your portfolio a numeric score ranging from zero to 1000.

Personally, I got a 106, which I thought was ridiculously low considering I hold stock investments via a myriad of mutual fund, plus a 401(k), SEP, and individual holdings. Ethan Berman, CEO of RiskGrades.com, says the majority of users report the same results.

“Your investments must be very diversified,” Berman explained to me. “This tool just underscores how effective diversifying your investments can be for mitigating risk.”

Indeed, spreading your money across a number of investments is simply the investing variation on the old adage “don’t put all of your eggs in one basket.” The easiest–and generally the cheapest–way to accomplish this is through mutual funds. If you can’t afford brokerage account minimums or prefer to avoid fees for individual stock trades, mutual funds offer immediate diversification–even with a very small investment.

According to Allyson Lewis, a certified financial planner and author of The Million Dollar Car and $250,000 Pizza, investors may also be able to reduce some market risk through sector rotation. In other words, there are usually one or two sectors of the market that do well when other sectors are performing poorly.

“You might see a steep decline in basic materials or energy while such sectors as healthcare or technology are rebounding,” states Lewis.

So the lesson here is, don’t just diversify among utility stocks–which have historically yielded conservative returns, or high tech stocks–which offer great return potential but high risk. Diversify across a number of different market sectors to benefit from the rise and fall of the entire market across the board–no matter the market environment.

Quality Lewis says some of her favorite words in a research report are “the world’s largest.” That may sound elementary, but consider the following:

• The world’s largest retailer is Wal-Mart.
• The world’s largest software manufacturer is Microsoft.
• The world’s largest electrical manufacturer is General Electric.
• The world’s largest pharmaceutical company is Merck.

If you did nothing but invest in the world’s largest of all these various market sectors, you’d have a pretty respectable portfolio. And a fairly high risk one as well. Lewis refers to these stocks as core holdings.

They tend to be large, well known companies whose growth is expected to continue and whose profits are projected to increase over time. “I recommend you begin with quality. Buy the stocks of companies whose products and services you use everyday,” says Lewis.

“Then you can increase your risk and venture into smaller, more speculative stocks after doing your homework.” If you’re looking to incorporate a little more risk into your portfolio, you couldn’t do much better than adopt this philosophy.