Before you read on, what do we mean by “risk”? Risk can be defined in many ways but to put it simply, risk is the chance of financial loss. The more risk you have the more chance of financial loss.
Fortunately, there are many ways to manage risk within your portfolios. One way is asset allocation, which aims to diversify your mix of assets among stocks, bonds, cash, alternatives, etc. Each asset class has a different sensitivity to changes in economic or market conditions. For example, U.S. Large cap stocks are more volatile, riskier, than other assets but they provide more growth.
During the bull market of the mid 1990’s and early 2000’s, money poured into equities – often into risky tech stocks. When a bear market followed 9/11, those risky equity stocks plummeted, devastating those stockholders.
For those investors who held a more diversified mix of assets in their portfolio they did much better, however, that’s only 1 component to managing portfolio risk.
Another component is correlation. You don’t want your investments highly correlated with each other. Meaning you don’t want your investments to respond to market declines all the same way. You increase the risk of losing your money.
The goal of risk management is to take on the amount of risk that aligns with your long-term financial goals using the different components of risk management.