Is Your Portfolio Hanging By a Thread, or Secured by a Safety Line?
Not long ago the ten members of our management team found ourselves taking turns climbing solo up a thirty foot telephone pole as part of a two day teambuilding and management retreat. Shouts of “belay on?” and “on belay!” (terms used by rock climbers to indicate whether a safety line has been secured) were heard as we carefully worked our way upward. When you are clinging to handholds thirty feet above the ground a safety line is welcome insurance against disaster.
A safety line is a simple solution to a simple problem. But as our world becomes more and more complex, how do we deal with all manner of uncertainty and risk? We can buy insurance to address the more obvious types of risk and unforeseen catastrophes that might befall us in our daily lives; for example auto, homeowners, medical, and life insurance. But what about the less obvious types of insurance that are critical to your financial future, such as insurance for your investment portfolio?
Insurance does not eliminate risk. But it can spread the potential risk of a catastrophic event to others…for a fee, of course. What type of insurance could investors have obtained to protect themselves against the NASDAQ meltdown from 2000 to 2002? What kind of insurance can an investor put in place to protect against some future meltdown or catastrophe?
One of the cardinal rules of investing, and maybe the most valuable, is to avoid a major, and potentially devastating, blow to the value of one’s portfolio. Consider that a 50% loss in a portfolio requires a 100% gain just to get back to even. The law of compounding (the continual growth of income upon an original investment and it’s earned income over time becomes geometrically magnified given enough time) can work for or against us. As Albert Einstein once noted, the law of compounding is the most powerful force in the universe. Yes, he was talking about physics. But when you suffer a major loss in your investment portfolio it can feel like the forces of the universe are aligned against you.
The growth of various forms of risk control have increased exponentially over the past twenty years. Does this mean that the overall risk of the market has decreased? No, it doesn’t. However, it does mean that you have many more options to reduce your personal exposure to risk in your investment portfolio — from derivatives to hedge funds to credit swaps to fixed annuities — there is no shortage of sophisticated alternatives to manage risk. You can literally attach multiple safety lines to your portfolio to protect against unforeseen slips, falls, and catastrophes. At Singer Burke and Company, we have experienced great success with a core/satellite strategy for wealth management that uses various forms of risk control to spread the risk of uncertainty in the markets.
So as you’re climbing your own personal wealth ladder, here is one question you may want to ask yourself, or those advising you: What safety lines, or insurance policies, exist to protect your assets from the uncertainty inherent in the ever-increasing complexity of the financial markets?
Risk Management Strategy Definitions
- Derivatives—A financial security such as an option or future whose value is derived in part from the value and characteristics of another security, the underlying asset.
- Hedge Funds—A fund that may employ a variety of techniques to enhance returns, such as both buying and shorting stocks according to a valuation model.
- Credit Swaps—A bilateral over-the-counter (OTC) contract in which the seller agrees to make a payment to the buyer in the event of a specified credit event in exchange for a fixed payment or series of fixed payments.
- Fixed Annuities—Contracts in which an insurance company or issuing financial institution pays a fixed dollar amount of money per period.
- Core/Satellite Strategy—A portfolio consisting of a "core" of traditional stocks and bonds augmented with alternative "satellite" investments such as real estate, commodities, hedge funds, private equity, etc.