Now that JPMorgan Chase has racked up losses of $2 billion and counting from risky derivatives trading, many individuals may be relieved that they have avoided this type of investment like a bad cold.
After all, most individual investors don't have the money or the stomach for such complex, high-risk investments. Yet that doesn't mean that they're aware of the risk levels posed by their portfolios of conventional investments. These risks could be far greater than you ever imagined.
Often, such risks can be discovered not by turning over every rock, but by looking at your investment landscape from a high vantage point. Looking at your holdings from a detached distance, you'll be better able to see risks may that have been lurking in your portfolio year after year, threatening or actually reducing your investment returns.
One of the most common risks imperiling portfolios is being over-invested in a single company. Routes to this risk include:
• Investing too much in a company that looks hot. In the late 1990s, Enron was a high-performing stock, and many investors bought in high -- only to regret it. These investors, and those who owned Lehman Brothers in 2008, were pummeled when these companies went bankrupt. The answer, of course, is diversification: spreading your investment among different companies in different industries.
• Owning too many shares of the company you work for — meaning that your employment income and your financial future are linked directly with the fortunes of the same company. If you work at a company that offers stock options or discounted shares, and you've taken advantage of this benefit, there's a good chance that you own way too many of your employer's shares for your own good.
Offering equity to employees is a time-honored way for companies to encourage employee loyalty and give them a strong incentive to work hard to increase the company's value. But over time, you can get over-weighted in this equity, increasing the chance that if you lose your job because of poor corporate performance, your nest egg will shrink when you need it most. Most Enron employees had a high concentration of Enron stock in their portfolios, so they had little to fall back on when they hit the bricks.
To reduce this risk, consider selling some of your shares gradually over time. If you think this is disloyal and you work for a public company, you might want to have a look at your top bosses' trading filings with the Securities and Exchange Commission. You'll see that many of them regularly sell shares. After you sell some of yours, consider investing the money in completely unrelated companies to diversify your portfolio to lessen risk.
• Being over-invested in a community where the local economy is dominated by a single employer. If you live in a small town where nearly everyone works at the same large employer and the bottom falls out after you've purchased rental property, you'll probably have to lower these rents to get tenants. This is especially distressing if you yourself work at the big employer.
• Having too much of your wealth in an annuity. If the insurance company that holds your annuity goes belly-up, that's the end of the annuity income stream. By investing all or most of your assets in this annuity, you took on high risk because you concentrated your investment in a single company rather than spreading it out, or diversifying it, by putting your eggs in different baskets.
Another common form of risk is overlap risk in mutual funds. All too often, investors put their money into funds that own many of the same stocks or companies of similar sizes, even though the reason many people own several funds is to diversify their investments. By checking fund company websites regularly to see what companies these funds own, you can get a good idea of your risk concentration and see if you need to cash out of some funds and buy others with different holdings.
Many investors also are exposed to considerable risk because they fail to adequately diversify international investments. For example, having too much of your portfolio in emerging markets is a bad idea. But it's far worse to have too much of your emerging-markets money in one country or region; this increases risk exponentially. This error stems from viewing all emerging markets as the same, when they are actually quite different.
Also watch out for the risks posed by an inability to withdraw money from an investment quickly enough. This lack of flexibility may block you from taking advantage of lucrative investment opportunities. Bernie Madoff's clients, unwitting victims of the biggest Ponzi scheme in history, knew they were facing liquidity risk because they could only take money out once per quarter.
While being wary of risks is always a good idea, you can take it too far. Ironically, if you're too risk averse, you run the risk of falling short of your goals investing for retirement. Let's say you're 25 years old and shell-shocked from the market meltdown of 2008, so that instead of stocks, you have all your assets in low-risk, low-return investments like money market funds and Treasury bonds. Chances are you'll miss out on opportunities for significantly higher returns before you hit 65, even if the stock market crashes a few times, because you have 40 years to recover from setbacks.
Regarding actual investment risks, much risk management or prevention comes down to saying, "What if this happens? What if that happens?" Apparently, the right people at J.P. Morgan didn't say this enough — but you can.
Ted Schwartz, a Certified Financial Planner®, is president and chief investment officer of Capstone Investment Financial Group http://capstoneinvest.net. He advises individual investors and endowments, and serves as the advisor to CIFG UMA accounts. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on achieving their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at email@example.com.