Investors are concerned that a market catastrophe will deplete their savings and limit their retirement income. When the media reports on how much the stock market has fallen in a particular day, month, or quarter, it plays on this anxiety. There isn't a lot of emphasis on the larger picture or putting market pullbacks in context. Planning and perspective can be useful remedies for low-risk investors.

The Efficient Frontier

For an elegant solution to the complexity of figuring out how to diversify your investments, Harry Markowitz won a Nobel Prize in the 1990s for his pioneering work on a model called, The Efficient Frontier.

Mr. Markowitz identified that for a certain amount of risk, you should expect a certain amount of return (low risk, low return). And, that by adding some higher risk investments to your mix, over time, you can actually reduce the overall risk of your investment portfolio. But, at a certain level, taking on too much risk won’t get you any further potential return.

How it Works!

Let’s say you’re a fairly low risk investor. You might think having all your money invested in bank notes or in bonds or bond funds are a safe bet. Interest rates are low, but maybe you’re all about protecting your principal. What Markowitz’s model revealed is that by adding some stable large company stock into your mix for example, you could offset the inherent risks that come with interest-bearing investments such as interest rate risk. That risk is when you lock into a note or bond and interest rates go up. You’re then locked in at the lower rate. Also, by investing in assets that all move in different directions at different times, you can reduce the overall and long-term risk of your portfolio. This is called Negative Correlation. It sounds complex but let’s simplify it.

Let’s pretend you’re being offered the opportunity to invest in a resort town. There are only two options for you; the umbrella company and the store that sells suntan lotion. If you opt for the umbrellas, you’re hoping it will rain a lot. But if you go with the suntan lotion option, you’re wagering on lots of sunny days that year. But what if you’re wrong? Wouldn’t you be better off splitting your investments between the two offerings? Yes, you won’t make as much if you’re right, but you also won’t lose out entirely if you’re wrong. That’s sort of, at its basic level, the idea of negative correlation and having both stocks and bonds in your portfolio. You don’t want everything going up or going down with your investments at all times.

When it comes to diversifying your own investments, there are lots of factors to consider, but the Efficient Frontier Model gives you and/or your advisor a solid framework to base those choices on.

However, it’s not the only consideration. What makes sense on paper, doesn’t always pass your gut check or allow you to sleep at night.

Slowly Take on Investment Risk

Even Mr. Markowitz was reportedly not able to take on as much risk, when it came to his retirement savings, as his revolutionary model suggested he could. If a Nobel Prize winner weighs his comfort level with as much consideration as the numbers suggest, you can give yourself permission to as well.

Just don’t sit on the side lines of taking on too little risk for too long. A one percent difference in your investment return over the long run can make a big difference in your retirement savings. But jumping all in before you’re ready could cause you to sell and panic if you face a market downturn.

It’s often said that we’re much less risk adverse when investing in a bull market (stocks heading up in value) but as soon as it turns bear (stocks heading down in value), our true tolerance is revealed. That can be incredibly devasting to your portfolio if you become panicked during a market crash and sell. It’s a definitely a common error people make when they misalign their risk tolerance to their needs and current financial situation. It is why a financial plan is so important! It allows to continuously check if you’re aligned to your short-term and long-term plans and allows you to continually assess your needs and your changing risk tolerance.

Investors' concerns about market volatility and overall investment risk may be alleviated if they have the correct planning approach in place and understand the goal of their portfolio.