Investment strategies, approaches to portfolio management and even the idea of what true “financial health” have all undergone a serious makeover within even the last few decades. What has been the key driving factor putting these strategies and theories into question? Answer: risk.
THE CATALYST OF WEALTH MANAGEMENT
To better understand how risk has been the catalyst and driving element toward change in wealth management, it is worth looking at some of the ideas and theories that have been born out of wealth management evolution.
First, some definitions on risk:
- Personal Risk: risk that could jeopardize an individual’s most basic standard of living (such as from loss of employment or income, death, disability or natural disaster)
- Market Risk: risk resulting from exposure to financial markets (also commonly referred to as systematic risk)
- Aspirational or Idiosyncratic Risk: risk specific to an asset (such as a business) that has a risk of substantial loss
When combined and looked at through the lens of a “portfolio” these 3 forms of risk make up what is referred to as “total wealth.” In other words, what your total worth is at a given moment when considering your entire financial picture.
These concepts of “total wealth” and variations on risk types have come to be referred to as the “Wealth Allocation Framework.” This is simply a way to discernibly categorize your total financial makeup in a way that allows a wealth manager and yourself to make qualified decisions for how to best leverage current total wealth using calculated risk to build more wealth.
Here is a great graphic from Merrill Lynch illustrating that Wealth Allocation Framework through the lens of risk types:
BUT WHAT ABOUT “DIVERSIFY”
Yes, diversification has become key to mitigating risk while maintaining the ability to leverage it and continue to build wealth through strategic investments. But this isn’t something new. The strategy of diversifying an investment portfolio has been around for ages.
Today, this is known as “Modern Portfolio Theory.” As you could imagine, methods are constantly evolving and opportunities to invest and build wealth increase daily. Over the past few decades’ the ease and capability to access personal investment opportunities have also increased. As access to these opportunities becomes more widespread, as it has been throughout history, risk aversity also increases.
Investopedia defines Modern Portfolio Theory as: a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. Also called “portfolio theory” or “portfolio management theory.”
WHAT DOES THIS MEAN FOR ME?
The good news is that capability to build wealth is stronger and more accessible than it has ever been. The difficulty comes with the complexity involved in truly managing total wealth to ensure optimal results. If you have any questions about whether your retirement or wealth management plan is sound we recommend engaging in a no-cost consultation with a financial advisor of your choice.
If you happen to be in the Boise area feel free to get in touch with Jared Empey to start evaluating your wealth management approach today.