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Unit 3: Managing Investment Risks

If you need money in the short term for either a planned or unplanned expense, you could Notes
use the amount of the maturing bond to meet that need without having to sell a larger
bond in the secondary market.

How much Diversification?

In contrast to a limited number of asset classes, the universe of individual investments is huge.
Which raises the question: How many different investments should you own to diversify your
portfolio broadly enough to manage investment risk? Unfortunately, there is no simple or
single answer that is right for everyone. Whether your stock portfolio includes six securities, 20
securities, or more is a decision you have to make in consultation with your investment
professional or based on your own research and judgment.
In general, however, the decision will depend on how closely the investments track one another’s
returns—a concept called correlation. For example, if Stock A always goes up and down the
same amount as Stock B, they are said to be perfectly correlated. If Stock A always goes up the
same amount that Stock B goes down, they are said to be negatively correlated. In the real world,
securities often are positively correlated with one another to varying degrees. The less positively
correlated your investments are with one another, the better diversified you are.
Building a diversified portfolio is one of the reasons many investors turn to pooled investments—
including mutual funds, exchange traded funds, and the investment portfolios of variable
annuities. Pooled investments typically include a larger number and variety of underlying
investments than you are likely to assemble on your own, so they help spread out your risk. You
do have to make sure, however, that even the pooled investments you own are diversified—for
example, owning two mutual funds that invest in the same subclass of stocks won’t help you to
diversify.
With any investment strategy, it’s important that you not only choose an asset allocation and
diversify your holdings when you establish your portfolio, but also stay actively attuned to the
results of your choices. A critical step in managing investment risk is keeping track of whether
or not your investments, both individually and as a group, are meeting reasonable expectations.
Be prepared to make adjustments when the situation calls for it.

3.8 Modern Portfolio Theory

In big-picture terms, managing risk is about the allocation and diversification of holdings in
your portfolio. So when you choose new investments, you do it with an eye to what you already
own and how the new investment helps you achieve greater balance. For example, you might
include some investments that may be volatile because they have the potential to increase
dramatically in value, which other investments in your portfolio are unlikely to do.
Whether you’re aware of it or not, by approaching risk in this way—rather than always buying
the safest investments—you’re being influenced by what’s called modern portfolio theory, or
sometimes simply portfolio theory. While it’s standard practice today, the concept of minimizing
risk by combining volatile and price-stable investments in a single portfolio was a significant
departure from traditional investing practices.

Did u know? In fact, modern portfolio theory, for which economists Harry Markowitz,
William Sharpe, and Merton Miller shared the Nobel Prize in 1990, employs a scientific
approach to measuring risk, and by extension, to choosing investments. It involves
calculating projected returns of various portfolio combinations to identify those that are
likely to provide the best returns at different levels of risk.

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