THE BLOG
05/22/2013 12:46 pm ET Updated Jul 22, 2013

Helpful Tips for Managing Investment Risk

By Linda Descano, CFA, President & CEO, Women & Co.

I recently had a conversation with Jonathan Clements, Director of Financial Education at Citi Personal Wealth Management, on the topic of risk. What he said really surprised me, and I left with quite a lot to talk about with my husband and my financial professional. But what perfect timing! Scott and I were just about to sit down and take stock of our finances. We had been hoping to adjust our plans and portfolios based on where we are and where we want to be in one year and look at the long term, too. Admittedly, we were driven to make adjustments based on what had been going on in the markets. But, according to Jonathan, focus on the ups and downs of the market distracts us from more important -- and potentially more devastating -- risks to our long-term financial well being.

"All too often," Jonathan said, "we panic when the Dow swings 200 points, even though the immediate impact on many investors is actually pretty limited. Meanwhile, all too many families have no strategies in place to cope with loss of a job, becoming disabled, or paying for an extended stay in a nursing home, let alone premature death of one of the breadwinners. So, rather than focus on market swings, I would encourage you to focus on the basics like insurance and setting up an emergency fund."

Also often overlooked by investors are inflation and taxes, what Jonathan refers to as the "quiet killers of the investment world." He clarified, "When markets fluctuate, investors often flock to so-called 'safe' investments, such as CDs. But, when you factor in taxes and inflation, the real return on such investments often turns out to be zero or, in some cases, negative. With consumer prices on the rise, how is that going to help you maintain your lifestyle five, 10 or even 15 years from now?"

Another risk Jonathan pointed out is our tendency to invest in what we're comfortable with, such as our employer's stock. "Don't get caught up in the fact that you work there and you would 'know' if something was amiss. There are plenty of recent examples I could cite of employees who lost their life savings when their companies went under." The lesson here? Don't underestimate the power of diversification.

On a related note, Jonathan spoke about how we, as investors often are comfortable buying and owning investments that are rising in price. "We see the gains and we imagine more gains. We are proud to own investments with such fine performance. But, in truth, this popularity should be a big, red, flashing warning sign, as we discovered with stocks after the late 1990s bull market and with homes after the buying frenzy of 2005 and early 2006," he added.

When we think about investment performance and returns, many of us look to long-run average rates of returns, said Jonathan. But, in fact, what is as important is what's happening in the market when we are making buying or selling decisions. "Imagine you quit the work force in late 2007," Jonathan said, "And you thought you had this great heaping pile of retirement money. But over the next 18 months, the S&P 500 plunges 57 percent. And, as your stocks plunge, you also need income from your portfolio and that further erodes the value of your nest egg. That's sequence-of-return risk and it's potentially huge."

In effect, Jonathan says what we should hope for is a bear market while we are building our nest egg, so we have the potential to buy stocks for cheap, and for a bull market when we are exiting the workforce. To help manage sequence-of-return risk, he suggests working with a financial professional to transition a portion of our portfolio to more conservative investments as our target retirement date approaches.

Optimistic, confident people tend to be happier, cope better with stress and are more likely to succeed in their chosen profession. But watch out, because copious self-confidence also means a tendency to overestimate chances of a happy outcome. This can be a real handicap when it comes to investing, said Jonathan. "It encourages us to trade too much, to make undiversified bets, to believe that we can beat the markets. Rising markets often exacerbate our self-confidence and lead us to attribute gains to our own brilliance. It can blind us from seeing the inevitable bubbles that follow a buying frenzy."

And then there's the little issue of how we actually want to spend our most valuable asset -- our time. It's fun to imagine what we could do in retirement with all that free time, but at the end of the day, as Jonathan reminded us, we have to think about what we really want from our retirement.

Regardless of our dreams, we still must contend with the uncertainty of whether we will live one decade or three decades in retirement (the more the better in my view), as well as whether our family will need our financial support or whether we will need theirs. That's another great topic of discussion with the extended family.

Women & Co., a service of Citi, is the go-to personal finance source for women. By providing financial content, commentary and community, Women & Co.'s mission is to get women thinking and talking about personal finance. Founded in 2000, Women & Co. is one of the longest running personal finance websites dedicated to helping women strengthen their financial futures.