Risk Matters

Most investors bear an inappropriate level of risk for the goals that they value most.  At Chesme, we strive to educate our clients on the real risks of investing, to eliminate the unnecessary risks, and to minimize the remaining risks.

Underperformance Risk – the risk that an active mutual fund manager, while attempting to “beat the market”, will actually underperform the market.  This risk is almost 100% guaranteed for active investors.  Few, if any, active managers have demonstrated the ability to consistently beat their benchmarks over time.

Underperformance Risk can be completely eliminated through the use of low-cost index and enhanced index funds.

Behavior Risk – the risk of not maintaining your investment discipline through thick and thin, during good times and bad.  Often depicted as the “Behavior Gap”, Behavior Risk has cost investors dearly:  Research by Barclays found that Behavior Risk cost investors up to 20% of the returns they should have earned over a ten year time period.

Behavior Risk can be largely eliminated through careful planning and a disciplined investment process.

Agency Risk – the risk of using a non-fiduciary financial advisor.  Non-fiduciary advisors have little or no incentive to eliminate the many conflicts of interest that exist in the financial services industry.  This means that you cannot be assured that they’ll always put your interests first.  Their first duty is to their employer, not to their clients.

Fiduciary advisors, on the other hand, are legally required to always put their clients’ interests first.  They are most often found in smaller, independent investment firms (most commonly referred to as “Registered Investment Advisors”).  Fiduciary advisors don’t sell product; they simply provide objective and unbiased advice.  They strive to eliminate all conflicts of interest.  And they have no third-party relationships that might steer them to selling you products that you don’t need – their only source of income is what they earn from their clients.

Strategy Risk – Strategy Risk is the risk of implementing a poorly structured investment portfolio due to a lack of planning and/or a lack of knowledge about what works (and what doesn’t work) in investing.

Some common strategic portfolio errors include:

  • Taking more portfolio risk than is necessary to meet your most important financial goals
  • Investing in actively-managed mutual funds
  • Investing in hedge funds and other alternative investments
  • Holding concentrated positions in a handful of stocks or poorly diversified mutual funds
  • Owning long-term bonds
  • Chasing yield via preferred stock, junk bond and dividend “strategies”
  • Emphasizing growth stocks over value stocks
  • Ignoring small-cap stocks
  • Failing to rebalance

Strategy Risk can be eliminated through careful planning and adherence to a few timeless investment principles:

  • Global diversification – not just a few hundred stocks, but thousands of stocks via low-cost, passively-managed mutual funds.
  • Overweight value and small-cap stocks.  Value stocks tend to provide higher returns over time than growth stocks.  Similarly, small-cap stocks have provided higher returns than large-cap stocks.
  • Minimize term and credit risk in your bond portfolio.  In other words, don’t invest in long-term bonds, and keep the credit quality high.  Your allocation to bonds is your insurance policy.  It’s there to provide stability to your portfolio; to offset the volatility of the stock market.

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