Investors can learn valuable lessons from Wall Street, but the pros aren't always eager to reveal their secrets. Luckily, there is one common stock market misconception that's not too difficult to rectify -- and it happens to be connected to some of the most costly mistakes that retail investors make. Keep this "secret" in mind as you create and execute your investment strategy.
Gains are only part of the equation
We have an obsession with investment returns that seems deep-rooted in our psychology and society. Market headlines often grab attention with noteworthy gains and losses for indexes and individual stocks. The first big question financial advisors field from prospective clients usually involves historical returns. Casual conversations on the golf course or at cocktail parties often center on recent investment wins and losses.
None of this is really surprising. Investing is enticing because it allows us to take money and turn it into even more money. Returns are also an intuitive way to quantify performance, which resonates with people who like to keep score. Nonetheless, the hyperfocus on growth is one of the distinct advantages that Wall Street holds over the average investor.
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Asset management is a more nuanced exercise for professionals, and financial institutions have dedicated major resources toward understanding and limiting risk. Any competent financial planner, fund manager, or investment analyst diligently tracks other metrics alongside portfolio returns.
One of the best ways to improve investment performance is to recognize that risk management is just as important as growth.
Risk management is essential
Portfolio allocation isn't as simple as selecting a handful of stocks that you consider most likely to grow. Risk is an absolutely core consideration in asset management. It's important to strike the right balance in your asset allocation. Sound investing strategies identify major risks and quantify them. A portfolio should be built to maximize returns within a suitable level of risk, and results should be measured in a way that takes that risk into account.
There are a number of risks to consider when building an investment portfolio. For an individual security, the most prevalent risk is that a specific company, industry, sector, or geographical region will falter, which would negatively impact the performance of any associated stocks or bonds. Think about BlackBerry's flame-out during the early smartphone wars, or the simultaneous collapse of internet stocks during the Dot Com bubble. If we accept that we can't know the future, then the only effective way to deal with company-specific risk is to diversify. Instead of holding one stock or stocks from one industry, it's usually wise to hold at least a handful of positions across several sectors. That way no single bad investment can derail a portfolio. Index investing is the most comprehensive response to this risk, since it allows passive investors to own the whole stock market instead of individual companies.
For diversified portfolios, risk is often synonymous with volatility. The market as a whole should rise over the long term, but equities experience price fluctuations in the short term. Stocks with high growth potential tend to have high valuations and experience more volatility. This creates a positive relationship between risk and reward. Investors need to measure and manage volatility, and any returns need to be understood in the context of risk. A portfolio of growth stocks might outperform dividend stocks during a bull market, but it carries the potential for steeper losses -- which is exactly what we've seen over the past few years.
When you build an investment portfolio, consider metrics such as beta to ensure that your risk profile is suitable. When assessing performance, consider metrics like the Sharpe Ratio. This approach helps to isolate the impacts of good investment choices from market conditions.
Suitability is essential for investment planning
The dual focus on risk and return means that the best investment for one person might not be so great for another. This concept is often conveyed with the efficient frontier chart, which plots the relationship between volatility and returns. In theory, no point along the frontier is superior to any other because they all represent optimal combinations of risk and returns. A retiree can't endure the same amount of volatility as a 30 year old who is saving for retirement, and older investors usually have to sacrifice upside potential as a result. Different people should have different portfolio allocations, which naturally results in different performance.
Instead of singularly pursuing growth, it's a good idea to focus on suitability. Set your bounds by quantifying risk tolerance, time horizon, and investment goals. Then build a portfolio that can maximize returns within that framework. Make sure that you're being appropriately compensated for the risk that you're taking with your capital.
Wall Street has invested massive sums in professionals and technology that can track and manage risk -- it's not smart to ignore this part of the equation, but too many investors do exactly that. Obviously, returns are an important consideration when assessing the quality of an investment strategy. Still, you can drastically improve your long-term outcomes by taking cues from the pros.
