Protecting Your Wealth
Along with growing wealth, protecting the wealth that you already have is another primary objective for investors. There are a lot of factors that can affect the value of your assets, and they typically focus on risks of loss, and risks around purchasing power.
Protecting From Loss
Most people are familiar with the expression "without risk, there is no reward", but in investing, it should be noted that not all risk leads to the same likelihood of reward. The challenge in investing is to find the right balance of risk that will maximize potential for reward while minimizing potential risk.
Applying this approach into your investment strategy can be done by considering a risk/reward ratio, and by balancing your portfolio.
Risk in finance is usually described as the volatility in the price of a security, in which volatility is measured by the annualized standard deviation of the security. For example, if Stock A has a volatility of 20%, it means that the stock price has moved within +/- 20% for 68% of the time throughout the year. Most measures of volatility are based upon historical numbers, and while that is an imperfect measure, it can be a good starting point.
The first step in evaluating risk/reward of a security is to assess the volatility of a security by comparing it against the volatility of its asset class. For example, if stocks in general have a historical volatility of 15%, and Stock A has a historical volatility of 25%, Stock A is riskier than the broader stock market. The next step is to compare the return of the security with the return of the asset class. If Stock A generated a 10% return last year while the broader market did 20%, it is pretty obvious that it made a poor investment (volatility of 25% and return of 10% as compared to the market with a volatility of 15% with a return of 20%). But even if Stock A had a return of 30%, the extra 10% in return is canceled out by the 10% in volatility it has over the market. In such a case, when you are comparing similar securities, the deciding factor will often be to minimize risk.
Having a balanced portfolio is one of the easiest ways to improve the risk profile of your investments. A balanced portfolio as being one that is diversified across different assets with the goal of generating the highest return for a given amount of risk the investor is willing to take. Usually, this means that a balanced portfolio will be comprised of multiple low-correlated assets.
Bonds and stocks, for example, typically have a lower correlation to each other than would stocks and real estate. This is why investors will hold both bonds and stocks within their portfolio—the combination of the two provides balance. When stock prices decline, bond prices tend to rise, and vice versa. Advanced investors will also ensure that their portfolio is also be diversified within an asset class to include diversification across industries. This way, industry-specific risks are balanced out.
Protecting purchasing power
Purchasing power is how much you can buy of any good or service with each unit of currency you own. Protecting your purchasing power is a very important investment objective, because it can have a significant impact on an investor's bottom line. Inflation and currency are two essential risks to your purchasing power.
Inflation refers to the increase in the price of goods. This erodes your purchasing power because it means that $1 in 10 years will give you less than $1 today. A little bit of inflation (1-2%) is considered to be good for the economy, but inflation rates above 3% are seen as bad. Inflation is caused by a variety of different factors, but one of the simplest ways to "beat" inflation is to invest in assets that rise with inflation, like equities, as opposed to investments with a fixed return, such as bonds.
Understanding how inflation affects your purchasing power will help you decide how to mix your investments for the long run.
We often hear about the dollar rising or falling without understanding its connection to the underlying economy. In general, currency risk is an offshoot of international economics and does not necessarily imply a negative outcome for domestic consumers. On the other hand, the United States imports a lot of goods from other countries, and by paying more for those goods, our purchasing power declines. Managing currency risk for domestic investors is challenging because it is more nuanced.
Most domestic investors don't need to worry too much about currency risk, but they should still check their investments for overexposure to currency fluctuations. An example of this would be where an investor has purchased stocks in a company that is primarily in the export business or has the bulk of their sales generated overseas. If the dollar rises, the value of those sales (in dollars) decreases, and vice versa. Sometimes it can be advantageous to have currency exposure, but ultimately the risks you take should be the risks you are willing to take.