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Unit 3: Managing Investment Risks

your investments, learn about the methodologies and criteria the research company uses Notes
in its ratings. You might find some research companies’ methods more useful than others’.

Take a Broad View

While the past performance of an investment never guarantees what will happen in the future,
it is still an important tool. For example, a historical perspective can alert you to the kinds of
losses you should be prepared for—an awareness that’s essential to managing your risk. A sense
of the past can also tell you which asset class or classes have provided the strongest return over
time and what their average returns are.
Another way to assess investment risk is to stay tuned to what’s happening in the world around
you. For example, investment professionals who learn that a company is being investigated by
its regulator may decide it’s time to unload any of its securities that their clients own or that they
hold in their own accounts. Similarly, political turmoil in a particular area of the world might
increase the risk of investing in that region. While you don’t want to overreact, you don’t want
to take more risk than you are comfortable with.

3.7 Investing to Minimize Risk

While some investors assume a high level of risk by going for the gold or looking for winners
most people are interested in minimizing risk while realizing a satisfactory return. If that’s your
approach, you might consider two basic investment strategies: asset allocation and
diversification.

3.7.1 Using Asset Allocation

When you allocate your assets, you decide—usually on a percentage basis—what portion of
your total portfolio to invest in different asset classes, usually stock, bonds, and cash or cash
equivalents. You can make these investments either directly by purchasing individual securities
or indirectly by choosing funds that invest in those securities.

As you build a more extensive portfolio, you may also include other asset classes, such as real
estate, which can also help to spread out your investment risk and so moderate it.
Asset allocation is a useful tool in managing systematic risk because different categories of
investments respond to changing economic and political conditions in different ways. By including
different asset classes in your portfolio, you increase the probability that some of your
investments will provide satisfactory returns even if others are flat or losing value. Put another
way, you’re reducing the risk of major losses that can result from over-emphasizing a single
asset class, however resilient you might expect that class to be.
For example, in periods of strong corporate earnings and relative stability, many investors
choose to own stock or stock mutual funds. The effect of this demand is to drive stock prices up,
increasing their total return, which is the sum of the dividends they pay plus any change in
value. If investors find the money to invest in stock by selling some of their bond holdings or by
simply not putting any new money into bonds, then bond prices will tend to fall because there
is a greater supply of bonds than of investors competing for them. Falling prices reduce the
bonds’ total return. In contrast, in periods of rising interest rates and economic uncertainty,
many investors prefer to own bonds or keep a substantial percentage of their portfolio in cash.
That can depress the total return that stock provides while increasing the return from bonds.
While you can recognize historical patterns that seem to indicate a strong period for a particular
asset class or classes, the length and intensity of these cyclical patterns are not predictable. That’s

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