In the world of investing, risk and return are inseparable. However, the vast majority of the emphasis on Wall Street is dedicated to portfolio returns, while risk is often ignored.Failure to properly understand risk is probably the most common problem faced by investors today.

The key difference between risk and return is that returns cannot be controlled, while risk can be. Returns are generated by market forces that are beyond the influence of any single participant, and returns are therefore impossible to predict or control. Risk, however, can be controlled by adjusting the allocation of a portfolio between various asset classes, allowing the different types of investments to work together as parts of a unified whole. At Heritage, we avoid misguided and futile attempts to control market returns. We instead focus our efforts on controlling or eliminating unnecessary risks and on taking worthwhile risks on purpose.  We recognize risk on three levels:

Security Selection Risk – Many investors take on a large amount of avoidable risk by betting heavily on one stock, one sector or one country. Comprehensive diversification eliminates this risk and reduces future uncertainty by spreading investments among many different and relatively uncorrelated global asset classes. By diversifying among multiple asset classes, as well as within each asset class, individual stock risk is largely eliminated, while sector and country risk are dramatically reduced. The investor is left with exposure to only those particular risk factors that are necessary for increasing expected returns.

Market Timing Risk – Even if an investor has properly eliminated security selection risk, an additional risk arises if the investor attempts to make decisions about when to enter or exit the capital markets. This is known as market timing risk and is another significant obstacle for investors. By using a disciplined investment strategy and by remaining fully invested at all times, Heritage is able to remove speculative market timing risk from client portfolios.

Global Equity Risk – Certain risks are implicit in the stock and bond markets because of the volatility associated with economic growth, investor sentiment, interest rates, inflation and other global events. These risks must be borne by all investors and cannot be mitigated by diversification or discipline. Global equity risk can only be reduced by the addition of lower-risk assets to the portfolio, which is typically accomplished by using high quality bonds. At Heritage, we work with each client on an individual basis to determine the correct mix of equities and bonds in order to achieve the desired balance between global equity risk and portfolio return.

Risk is the most important and most misunderstood element of investing. We will therefore attempt to answer some of the most important questions pertaining to investment risk:

• Is it possible to completely eliminate investment risk?
  
  Yes, it is possible to eliminate investment risk. The way to do this is to simply invest your money in one-month United States Treasury Bills. The U.S. government is considered to be the highest quality creditor in the world, and therefore, an investment in short-term T-bills is essentially a guarantee against any loss of investment principal or interest.  

• If risk can be eliminated, why should anyone be willing to accept risk in a portfolio?
  
  The simple answer is, “No risk = no reward.” While it is true that U.S. T-bills constitute a risk-free investment, it is also true that U.S. T-bills provide very little in the way of investment returns compared with other investments such as corporate bonds and stocks. If we think about this logically, we can see that the market demands that this be true. If the expected return on corporate stocks, for example, were equal to or lower than the return on U.S. T-bills, no one would ever invest in corporate stocks. There would be no reason to invest in the riskier corporate stocks if you could achieve the same expected return with a risk-free T-bill. Therefore, corporate stocks must offer a higher expected return than T-bills in order to entice investors to buy them. This higher return is, in effect, an investor’s reward for taking on more risk. In a well managed portfolio, more risk = more reward.

• Is there a difference between short term and long-term risk?
  
   Yes. Short-term portfolio risk is driven by market volatility. As risky investments rise and fall over time, the holders of these investments are exposing themselves to the risk that they will need to “cash-out” during a downward trend in the market. Thus, dealing with short-term risk involves the ability to cope with uncertainty and to “stay the course” through difficult periods in the capital markets. Long-term risk, on the other hand, is associated with the deterioration of capital due to the effects of inflation. Any investor who does not utilize some of the higher expected return investment vehicles (such as corporate stocks) runs the risk that inflation will destroy the purchasing power of his initial investment. Historically, the long-term risk driven by the effects of inflation has been much more dangerous to an investor than short-term risk driven by volatility.

• Are certain types of risk avoidable?
  
  Yes. There are two types of risk: unavoidable and avoidable risk, or non-diversifiable and diversifiable risk. Academics refer to these as systematic and non-systematic risk. Certain risks are implicit in the capital markets because of the volatility associated with macro factors such as the global economy or the demand for equities and bonds. These risks must be borne by all investors and cannot be diversified away. However, many investors also bear a large amount of avoidable risk by betting on one country, one class of stock, or even a single stock. Comprehensive Diversification eliminates this diversifiable risk and reduces future uncertainty by spreading investments among many different and relatively uncorrelated asset classes. By diversifying among multiple asset classes as well as within each asset class, an investor will be exposed only to those particular risk factors that are absolutely necessary.

• If I already own fifty stocks, why do I need more diversification?
  
  Diversification is not defined by how many securities you own, but how the securities you own interact with one another. Owning fifty large cap U.S. stocks will not provide a great deal of diversification because they may all move lower at the same time in the case of a general slump in the U.S. economy. However, owning, small capitalization stocks, foreign securities, commodities, real estate investment trusts and bonds in conjunction with U.S. large cap securities protects against a general decline in large cap U.S. stocks, or in any single asset class.

• Is a well-run company always a great investment?
  
  Not necessarily. There is a common misconception among investors that if a company is a well-run “household” name, it must be a good investment. Investors must be aware that a good company does not always equate to a good investment because the price of the position (stock or bond) in the company could be significantly above the underlying intrinsic value of the company itself. If everyone knows that a company is well run, everyone will want to buy it. This buying pressure may increase the price to an unsustainable level, and although the company is still well-run, its stock or bond price could drop dramatically in response to adverse events beyond the company’s control. Investment risk, therefore, is still present in the stocks of even the best companies.

• Should I base my investment decisions on what has happened in the past?
  
  No. As investors are always told, “Past performance is not indicative of future results.” This statement is true in every sense. You should never invest based upon past performance because the past is simply not an effective predictor of the future. The fact that technology stocks showed outstanding performance from 1994-1999, did not prevent them from delivering disastrous results in 2000-2002. In early 2000 the perceived risk of these stocks was very low, but the actual risk was quite high, as investors learned over the next three years. Investment decisions should be based on investment science, and viewed as if every day were the first day of the investment life cycle.

The most important controllable risk in the field of portfolio management is the risk of not having a well-conceived investment plan or the ability to implement that plan, especially in times of uncertainty. Investing is an emotional process that takes acumen, patience and discipline. It is difficult not to panic when it feels like the world is falling in around you, as it felt like on September 11, 2001. It is just as difficult not to chase hot areas of the market when it feels like everyone around you is “getting rich”. Because the assumption of risk goes hand-in-hand with higher expected returns, risk can work to the investor’s advantage if it is approached properly. Risk is the vehicle that allows a good investment advisor to establish the right asset mix in each client portfolio. Risk should not be feared. It should be embraced and undertaken on purpose in order to provide a higher return in the portfolio.