Risk Tolerance and Diversification- More Important than Ever

Know Your Risk Tolerance

Investors should never take more risk than they have the ability, willingness, or need to take.  Violating this rule is what led to the failure of Lehman, Bear Stearns, AIG, and others.  They all took on so much leverage that they had to be right in their predictions all of the time, not just in the long run.

Diversification is the Key

Low correlating risky assets have a nasty tendency to have correlations rise just when those low correlations are needed the most.  Thus, investors should make sure their portfolios have sufficient, high-quality fixed income assets to reduce portfolio risk to an appropriate level.  Also, it is important to ensure the fixed income used in the portfolio is of the highest quality.  Investors should stick only with Treasuries, bonds of government agencies and the highest rated municipal bonds.  Also, municipal bonds should be judged based on the underlying rating, not the credit insurance.

Other fixed income investments such as high-yield (junk) bonds, convertible bonds, emerging market bonds and preferred stocks should be avoided, as their risks do not mix well with equity risks, thus could have the risk show up at the wrong time.  Those willing to take incremental risk should do so by increasing their equity allocation.  The incremental expected returns can then be earned more tax efficiently, and the risks can be for effectively diversified.