One of the clearest challenges in wealth management is trying to make real gains adjusted against things like inflation, taxes, and fees. To make consistent progress, you need to have an appropriately aggressive investment strategy. On the other hand, maintaining your wealth is just as important, and it's critical to factor in risk.
How do you strike the right balance between risk and aggression? Let's look at how wealth management advisors think about this problem.
Understanding Aggression and Risk vs. Gambling
It can seem hard to see where the line is between aggressively taking risks and simply gambling. However, taking risks involves venturing a portion of your wealth in a way where you should reasonably be able to make back your losses elsewhere if things go sideways on a particular investment. Gambling involves staking so much of your wealth on a specific bet that it would take decades to make back the losses or worse.
Why Risk Matters
Much of the profit that people make investing comes from gobbling up risk premiums. If you're one of the first people to put money into a real estate development, for example, you expect to get back more money than later investors because you jumped in before the project was a proven winner. That's your premium for accepting the early risks.
Risk premiums are everywhere. Folks who buy stocks during IPOs win risk premiums if those stocks jump months or years down the road. Investors in startup companies earn their risk premiums when they sell. Someone who buys high-risk municipal bonds versus low-risk ones earns more interest.
There are two dominant ways to mitigate risks while investing. First, you can diversify your assets and investments to ensure you're never putting too many eggs in one basket. Second, you can find a way to hedge your risk profile.
Maintaining a diversified portfolio is critical to wealth management. You don't want to have too much of your wealth in a single sector. Likewise, you want to over-invest in one or two assets in each sector. This is why wealth managers constantly stress the importance of diversification.
The best way to think about a hedge is to see it as a form of insurance. If you have a lot of investments in commercial real estate, for example, you might hedge your risk by purchasing aggressive and low-cost put options on banks that have massive CRE exposure. A collapse in commercial real estate value would likely lead to the put options paying out.