When markets climb into record territory, Wall Street-types start talking up risk management strategies. Here are three – and why they’re suspect:
- Dollar-Cost-Averaging – buying a position bits at a time, to “average” the overall cost basis of the security. Problem: money on the sideline waiting to come in is earning nothing.
- Mutual Funds – are promoted as the ultimate risk management tool. Problem is you’re paying twice; your broker who recommends them – and the mutual fund manager who manages the money. They’re often not that diversified – they’re tax-inefficient – and capturing dividends requires great timing.
- Diversification – buying securities with differing risk profiles so if one tanks – it doesn’t take the whole portfolio down. Problem: Spreading risk necessarily means compromising upside potential and overall returns.
Diversification sounds like a good idea – but there’s only one thing it does for sure: drive fee and commission income into the Wall Street machine.
Does it effectively mitigate risk? Like any form of insurance – you won’t know until you need it (experience a down market).
The more fundamental issue is that diversification is only relevant in a risky environment. If there were no risk in the first place, diversification would be unnecessary – and a waste of though energy.
Is “risk-free” investing possible? Yes. A relatively new growth strategy called equity indexing, captures much of the market’s upside movement, while eliminating all of its downside risk.