The Greatest Risk in Today’s Financial System

How a Portfolio Approach to Stocks Reduces RiskIf you have a serious commitment to the equity market, you know that it’s very easy to lose money with stocks. Even when market action is good, one wrong number or any small aberration has the potential to change investor sentiment on a dime. Today’s hottest stocks are easily tomorrow’s biggest losers; today’s financial engineering could lead to tomorrow’s market crash after a derivatives trade–gone-bad.

This is why it really is worthwhile to spend time thinking about investment risk and how a portfolio of stocks is vulnerable to the downside.

I firmly believe that capital preservation is just as important as the expectation of generating a return on investment from stocks at a rate that is greater than inflation. In today’s world, with artificially low interest rates and poor rates of return from bonds and cash, stocks are a huge asset class with tremendously higher risks.

Because of this, approaching equities from a portfolio perspective and building core positions in stable, dividend-paying businesses is a strategy that complements the more speculative approach of trying to achieve short-term capital gains.

Equity investors are well served by trying to “do it all” in the sense of having core positions in stocks that can be accumulated over time, along with a certain percentage allocated for risk-capital trades. (See “Two Steps to a Solid and Profitable Portfolio.”)

And for those less comfortable with the idea of selecting and managing a portfolio of individual stocks, there’s no reason why you can’t integrate active investing with passive investing. Index funds and exchange-traded funds (ETFs) are still great instruments in which to have exposure to equities, particularly if you want a position in a certain subsector or industry.

For example, an investor might want some exposure to biotechnology stocks, but they don’t want to pick individual companies. The same can be said for higher-yielding dividend funds, resource exposure, foreign stocks, or a benchmark index.

With pooled money, percentage weights in a portfolio are easy to adjust; for example, you don’t have to sell an entire stock if you want to lighten up on a particular investment theme.

An equity investor can actually do a lot with a portfolio of five to 10 stocks. Four or five core, long-term positions can cover quite a bit of global industry. More speculative, select positions can then be allocated to faster-growing investment themes.

But investment risk in equities is always material, and a portfolio approach to managing positions helps to mitigate this unavoidable reality.

I view income and growth as complementary investment styles. Sometimes referred to as the total return approach to equities, a combination of strategies works best to reduce market risk within a portfolio, while maintaining the potential for capital gains.

The adequacy of diversification is, of course, subjective. But complacency is something that easily affects capital markets and memories are short.

As events in recent history illustrate, institutional money is vast and fleeting. Investors can’t quantify the amount of risk imbedded in today’s financial system, and this in itself is one of the greatest risks of all.