Ask the Financial Expert: How Do You Balance Investment Risk and Return?
Each month our financial experts answer your questions about finance and investing.
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What is the right level of risk, and what’s the tradeoff?
Ron: I’d like to start with a story. I was at another insurance company in a chief investment officer position, and the chairman of that company said, “Ron, I’d really love to see a return of X in the portfolio.” It was a pretty high number, and my response to him was, “Well, you know, we could deliver any expected level of return; but you might not like the amount of risk that you have to take in order to get there.” And that started a whole discussion between the two of us about how much we could withstand in volatility of returns. I think that’s a major part of the equation: What kind of return do you expect to get, and how much volatility in that return are you willing to withstand? Once you understand that, you can begin to balance your risk and return objectives.
Ron, when you’re investing a company’s money, you have some constraints about how much risk you can take, right?
Ron: That’s right. Let’s say John is representing individual investors; I’m representing corporate investing (the institutional side). We may both have an identical view of the economic environment or the investment climate, but because our risk tolerances are so radically different, we’re going to invest in a different way. So for the general account at Northwestern Mutual, we know that even if there’s a severe market correction—and we’re not expecting it right now, but if there was a 50 percent market correction—the general account is managed in a way that we still would anticipate the highest possible credit ratings for Northwestern Mutual. What that means is we’re going to hold a much lower level of risk assets to be able to withstand a correction and maintain the rating. So, for us, we wouldn’t go much above a 17 percent allocation to risk assets because of our tolerance of risk.
When it comes to individual investors, you’re going to run into individual investors who have different feelings about risk and different needs for returns, correct?
John: As Ron was talking about with the general account, they’re very clear in what their objectives are. I think, for any individual investors, they need to do the same thing. What are they trying to accomplish with their money, what are their goals, what is their time frame, and then ultimately how much risk are they willing and able to take on?
One concern that we have is for individuals who get worried that the market’s going to go down. They’re worried about being in an investment that’s too risky, so they go to very low-risk investments—federally insured bank CDs or U.S. Treasuries. Those investment vehicles may only offer 2 to 2.5 percent return each year. If you’re in an environment in which inflation gets up to 3 or 3.5 percent, at the end of the time period you actually have less in purchasing power than you did at the beginning. So when we start talking about risk and low-risk investing, believe it or not, sometimes if you’re not taking enough risk, that is a risk in and of itself.
So how can an investor determine an appropriate level of risk for him- or herself?
John: Well, as the famous saying goes, “Everything I need to know I learned in kindergarten.” Start thinking about Goldilocks. The porridge was too hot; the porridge was too cold; the porridge was just right. It’s similar when it comes to putting together a portfolio for an individual investor: There’s going to be a level where there’s too much risk; there’s going to be a level where there’s not enough risk. You want to find, based on your objective, your time frame, and your tolerances, what that “just right” amount of risk is for a portfolio so that you can meet your goals while still being able to sleep at night.
Hear more from Ron and John in the Ask the Financial Expert podcast, moderated by Mark McLennon, Northwestern Mutual’s vice president of investment product development.
Do you have a question for our financial experts? Email it to us at: AskTheExpert@northwesternmutual.com.
Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) (life and disability insurance, annuities, and life-insurance with long-term care benefits) and its subsidiaries. Northwestern Mutual Wealth Management Company®, Milwaukee, WI, (fiduciary and fee-based financial planning services) subsidiary of NM, federal savings bank. Northwestern Mutual Investment Services, LLC, (securities) subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.
The opinions expressed are those of Northwestern Mutual as of the date stated on this recording and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources. All investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss.
Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market. With fixed income securities, such as bonds, interest rates and bond prices tend to move in opposite directions. When interest rates fall, bond prices typically rise and conversely when interest rates rise, bond prices typically fall. Bond and bond fund investors should carefully consider risks such as: interest rate risk, credit risk, liquidity risk and inflation risk before investing in a particular bond or bond fund.