Taking Calculated Risks
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Welcome to Week 5 of our Wealth Management series for senior healthcare executives. If you missed any of the previous discussions, you can catch up here:
This week, we’ll explore the concept of taking calculated risks in investing, focusing on evidence-based strategies that align with the principles of Fama/French. Understanding how to evaluate and manage risk is essential for achieving your long-term financial goals.
Understanding Calculated Risks
Calculated risks involve making informed decisions based on empirical evidence, where the potential rewards outweigh the possible downsides. Unlike speculative risks, calculated risks are grounded in decades of academic research and are designed to systematically capture market premiums.
The Fama/French Approach
The Fama/French Three-Factor Model, developed by Eugene Fama and Kenneth French, extends the traditional Capital Asset Pricing Model (CAPM) by incorporating two additional factors: size (small-cap versus large-cap) and value (high book-to-market versus low book-to-market). These factors are based on empirical data showing that small-cap stocks and value stocks tend to outperform the market over the long term.
Three Factors to Consider:
By focusing on these factors, you can make calculated investment decisions that are likely to yield higher returns over time while managing risk appropriately.
Strategies for Taking Calculated Risks
Diversify Across Factors
Overview: Diversifying across multiple factors, including market, size, and value, reduces the unsystematic risk associated with individual stocks or sectors.
Why It’s Important: Focusing on a single factor can expose your portfolio to unnecessary risk. A diversified approach allows you to capture returns associated with different risk premiums while maintaining a more stable overall portfolio.
Solution: Invest in a diversified portfolio that includes small-cap and value stocks alongside more traditional large-cap and growth stocks. Consider funds or strategies that are designed to capture these factors systematically, such as those offered by Dimensional Fund Advisors.
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Focus on Evidence-Based Strategies
Overview: An evidence-based investment approach relies on data and rigorous academic research to guide decisions, rather than speculation or market timing.
Why It’s Important: Empirical evidence supports the idea that certain factors, like size and value, deliver higher returns over time. An evidence-based strategy minimizes emotional decision-making and focuses on long-term outcomes.
Solution: Implement a strategy that aligns with the Fama/French model, focusing on diversified funds that target small-cap and value stocks, while maintaining exposure to the overall market. Avoid speculative bets and instead, rely on proven methods.
Implement Disciplined Rebalancing
Overview: Rebalancing your portfolio regularly ensures that it stays aligned with your risk tolerance and investment goals, particularly as market conditions change.
Why It’s Important: Without rebalancing, your portfolio can drift from its intended allocation, increasing risk in ways that may not align with your original strategy.
Solution: Set a regular schedule for rebalancing your portfolio, such as annually or semi-annually. This will help you maintain your desired exposure to the factors that are expected to drive long-term returns, even as individual investments perform differently over time.
Taking calculated risks is essential for growing your wealth and achieving your financial goals. By focusing on evidence-based strategies grounded in the Fama/French model, you can make informed decisions that balance risk and reward. This approach ensures that your investment strategy is aligned with long-term success.
Next week, we’ll explore how to adapt your investment strategy to changes in the financial landscape. Stay tuned!
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About Me
John Montgomery is a wealth advisor exclusively serving senior healthcare executives. He has a passion for helping individuals and families grow and protect their wealth.
Learn more at www.montgo.co