When is There Too Much Risk in Your Portfolio?
When is There Too Much Risk in Your Portfolio?
When you hear about the market you are probably hearing that it went up or it went down. While big moves may be newsworthy, they create more questions than answers. Is it better to invest when the market going up or down? When is the market too high to invest?
Left to their own devices, many people pick the assets with the best historical growth to make their portfolio. You likely won’t be successful with this approach long term, because past performance is not a good indicator of future performance. When it comes to constructing a solid portfolio, don’t worry about managing performance, worry about managing risk.
Many people see risk as the likelihood an investment will lose money. By this definition any investment that is losing or has recently lost money is poor. But every investment has the potential to go down. Recessions are inevitable, and you really can’t avoid being impacted by them.
Risk is not determined by which direction an investment moves, but how much it moves. That means that when you choose last year’s best performing asset because of its high return, a high level of risk comes along with it. If you remember anything from this article remember this, investment performance does not equal investment quality. If you don’t believe me, look at the many tech stocks out there with great stock earnings despite never having made a penny in profit.
When we get out of the performance paradigm and into the risk paradigm, creating a plan to pursue your goals becomes easier. Just remember that no one can predict the future, so the goal of any advisor is not to make you money, but instead to give you the best chance of pursuing your goal regardless of what the market is doing. When your risk is too high a market downturn can put your goals off track. Here are three considerations investments advisors take when it comes to risk.
Understanding Your Risk Tolerance
The best plan is not the one that makes you the most money, it is the plan you are most likely to stick with. Over the last several years I have come across many people who sold during the 2008 recession and never bought back in despite all the market gains since. You may think their mistake was getting out of the market or not getting back in. Those are symptoms, the real mistake was investing in a plan that was too risky for their tolerance.
Remember recessions are inevitable. You need a strategy that you can stick with through the down periods. People want to believe they can experience the good times and avoid the bad. They gravitate towards great asset performance with no thought to the downside, and when the other shoe drops it is simply too much for them to take. Don’t make that mistake. How much could your portfolio lose in a bad year? If the answer is too much, the time to figure that out is before you invest, not after the loss.
Understand Your Time Horizon
So you’ve figured out your risk tolerance, and you’ve decided you can take any market downturn that comes your way. Well before you go all in on high-risk investments consider you time horizon, or how long until you need the money. When a high-risk investment loses it can take years to come back, you may not have that time.
Consider “the lost decade”, a period between 2000 and 2010 when the S&P 500 famously made next to nothing because of the two recessions. If you were investing money in 2000 and spending that money in 2010 you needed that growth, and the lack of it would translate to not pursuing your goals on time. On the other hand, if you were investing in 2000 and spending in 2040, the impact would be less severe.
Let’s say you have a shorter time horizon or a low risk tolerance and need to invest in something outside the stock market to increase your chances of pursuing your goals. What else is there to invest in? Portfolio construction uses lower risk assets such as bonds or cash that can give you the edge in the bad times. The problem? I’ve yet to meet someone who loves investing in bonds and cash. That’s because when the stock market is shooting up, they often give you single digit returns. That’s because typically low risk investments go up and down very little compared to the stock market, that’s what makes them low risk.
But these low-risk assets can help you in recessions. That is because during a recession or periods of low economic growth bonds, especially government bonds, tend to perform better than stocks. (Ang, 2014)[i] The price you pay for this lower volatility is lower overall return, but remember the goal is not performance. The goal is to pursue your goal regardless of what the market does, and trust me when I tell you that you don’t want a recession, an election, or a war in Eastern Europe deciding if you reach an important milestone in your life. Asset allocation could help keep risk in line with your goals.
Every investor fights two emotions: greed and fear. When the market is going up you want all the risk in the world, and when it’s going down you want no risk. But we know that you can’t have your cake and eat it too, managing risk from the start is needed to work towards your goals in the long term.
If you are having a hard time figuring out what risk you need, what asset allocation is correct, or just talk about the risk profile of your current investments, let us know, we can help!
-The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced in historical and is no guarantee of future results.
-All investing involves risk including loss of principle. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
-Asset allocation does not ensure a profit or protect against loss.
[i] Ang, Andrew (2014) Asset Management: A Systematic Approach to Factor Investing (Financial Management Association Survey and Synthesis) New York, NY: Oxford University Press