Wall Street's Big Secret Will Never Tell You About Investing

Wall Street’s Big Secret Will Never Tell You About Investing

(Ryan Downie)

Investors can learn valuable lessons from Wall Street, but the pros aren’t always eager to reveal their secrets. Luckily, there’s a common stock market misconception that’s not too hard to rectify — and it’s tied to some of the costliest mistakes retail investors make. Keep this “secret” in mind when creating and executing your investment strategy.

Earnings are only part of the equation

We have an obsession with returns on investment that seems deeply rooted in our psychology and our society. Market headlines often attract attention with notable gains and losses for indices and individual stocks. The first big question that financial advisors ask potential clients is usually about historical returns. Casual conversations on the golf course or at cocktail parties often focus on recent investment gains and losses.

None of this is really surprising. Investing is attractive because it allows us to take money and turn it into even more money. Yields are also an intuitive way to quantify performance, which resonates with people who like to keep score. Nonetheless, the hyper-emphasis on growth is one of the distinct advantages Wall Street holds over the average investor.

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Image source: Getty Images.

Asset management is a more nuanced exercise for professionals, and financial institutions have devoted significant resources to understanding and mitigating risk. Any competent financial planner, fund manager, or investment analyst diligently tracks other metrics alongside portfolio returns.

One of the best ways to improve investment performance is to recognize that managing risk is just as important as growth.

Risk management is essential

Portfolio allocation isn’t as simple as picking a handful of stocks that you consider most likely to grow. Risk is an absolutely essential consideration in asset management. It is important to find the right balance in your asset allocation. Sound investment strategies identify major risks and quantify them. A portfolio should be constructed to maximize returns within an appropriate level of risk, and results should be measured in a way that takes that risk into account.

There are a number of risks to consider when constructing an investment portfolio. For an individual security, the most common risk is that a specific company, industry, sector or geographic region will weaken, which would negatively impact the performance of the associated stocks or bonds. Think about Blackberrydied out during the early smartphone wars, or the simultaneous crash of internet stocks during the Dot Com bubble. If we accept that we cannot know the future, then the only effective way to manage firm-specific risk is to diversify. Instead of owning one industry stock or stocks, it’s usually wise to own at least a handful of positions across multiple sectors. This way, no bad investment can derail a portfolio. Index investing is the most comprehensive answer to this risk, as it allows passive investors to own the entire stock market instead of individual companies.

For diversified portfolios, risk is often synonymous with volatility. The market as a whole is expected to rise in the long term, but stocks experience price swings in the short term. Stocks with high growth potential tend to have high valuations and experience greater volatility. This creates a positive relationship between risk and reward. Investors must measure and manage volatility, and any returns must be understood in the context of risk. A portfolio of growth stocks can outperform dividend stocks during a bull market, but it carries the potential for greater losses – which is exactly what we’ve seen over the past few years.

When building an investment portfolio, consider parameters such as beta to ensure your risk profile is appropriate. When evaluating performance, consider parameters such as the Sharpe ratio. This approach makes it possible to isolate the impacts of good investment choices from market conditions.

Fit is key for investment planning

The dual focus on risk and return means that the best investment for one person may not be so good for another. This concept is often conveyed with the efficient frontier chart, which plots the relationship between volatility and returns. In theory, no point along the border is superior to another because they all represent optimal combinations of risk and return. A retiree cannot withstand the same volatility as a 30-something saving for retirement, and older investors generally have to sacrifice upside potential as a result. Different people should have different portfolio allocations, which naturally results in different performance.

Instead of just pursuing growth, it’s a good idea to focus on fit. Set your limits by quantifying risk tolerance, time horizon and investment goals. Then build a portfolio that can maximize returns within that framework. Make sure you are properly compensated for the risk you take with your capital.

Wall Street has invested massive sums in professionals and technology that can track and manage risk – it’s not wise to ignore this part of the equation, but too many investors are doing just that. Obviously, returns are an important consideration when evaluating the quality of an investment strategy. Still, you can dramatically improve your long-term results by taking inspiration from the pros.

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Ryan Downie has no position in the stocks mentioned. The Motley Fool recommends BlackBerry. The Motley Fool has a disclosure policy.

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