April 01, 2015

Investment Perspectives: Risk-Minimization Techniques

Cynthia Sharp
From The Lawyer's Guide to Financial Planning

Some investors gamble with the hope of achieving an ultrahigh return. However, those seeking financial security are most likely inclined to invest with a view to minimizing risk. Two classic strategies—asset allocation and diversification—are outlined below.

Asset Allocation

An investor must consider a number of factors before deciding on the appropriate allocation of investment funds among the broad asset classes that include stocks, bonds, and cash equivalents, and their subcategories. The primary considerations are age, current financial position, amount to be saved each year, length of time the money will be invested, and risk-tolerance level. Software is widely available to assist investors with staying on track from an allocation standpoint. Of course, financial advisors can assist in this regard.

Those with longer investment horizons may opt for stocks even though the investment carries varying degrees of risk. Because the stock market generally has the strongest long-term return, the gamble may be justified since time remains to recoup unanticipated market losses.  investments that will be tapped in the near future should be more conservatively invested, which means an emphasis on bonds and cash equivalents. For example, a person planning to save enough to have a down payment on a home in two years would not want to enter into a risky investment. On the other hand, a 30-year-old putting away money for an anticipated retirement date 35 years hence will probably have a higher risk tolerance. 

ASSET ALLOCATION ILLUSTRATIONS

George is 35 years old, has a net worth of $50,000, and plans to save at the rate of $12,000 per year. He self-classifies his risk tolerance as 5 (balanced). The suggested asset allocation is: 75 percent stock, 10 percent bonds, and 15 percent cash equivalents. At age 70, with a net worth of $2 million, he plans to save no more and wishes to withdraw 4 percent per year. The suggested asset allocation at that point is: 44 percent stock, 40 percent bonds, and 16 percent cash equivalents.

Lynn is 60 years old, has a net worth of $1 million and plans to save at the rate of $40,000 per year. She self-classifies her risk tolerance as 8 (aggressive). The suggested asset allocation is: 60 percent stock, 24 percent bonds, and 16 percent cash equivalents. At age 80, with a net worth is  .5 million, she plans to save no more and wishes to withdraw 4 percent per year. The suggested asset allocation at that point is: 35 percent stock, 48 percent bonds, and 17 percent cash equivalents.

Diversification

“It is the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.”

—Sancho Panza
Don Quixote
(Part I, Book III, Chapter 9) by Miguel de Cervantes

A diversified portfolio represents different categories of investments as well as diverse subclasses within a particular category. Investment options other than the three major categories should be evaluated. Real estate investment considerations are discussed in Part One, Section Four. Diversification may reduce risk since classes of assets normally do not simultaneously react to economic conditions in the same manner. A decline in stock values may be occurring while bond values are on the rise. The same holds true within an asset class. For example, an investor may hold both domestic and international stocks or may hold both corporate bonds and municipal bonds.

Most busy lawyers do not have time to conduct sufficient background research and the task is best left to financial professionals. Many choose to participate in pooled investments, such as mutual funds, exchange traded funds, and lifecycle funds, since the manager is responsible for all diversification and asset allocation decisions.

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Cynthia Sharp


Cynthia Sharp (J.D., LL.M. (taxation)) dedicated close to 30 years building a successful law practice serving thousands of clients. At the pinnacle of her career, she sold her interest in the practice and established The Sharper Lawyer. She is also a contributor to the American Bar Association’s Publications Board of Solo, Small Firm and General Practice Division’s upcoming publication The Lawyer’s Guide to Buying, Selling, Merging, and Closing a Law Practice. Cynthia’s social media column appears on a regular basis in the GPSolo eReport. Take a look at the website and blog of The Sharper Lawyer for up to date information and commentary on relevant topics: www.thesharperlawyer.com.