Open any newspaper or personal finance magazine and you will inevitably be bombarded with any number of ads touting market-beating performance, best returns within a specific category, etc. Have you ever stopped to wonder why there is never any mention of risk? What do you think is the single most important factor in making good investment choices and experiencing good investment results? In two words: “understanding RISK!”
Our typical client is female and over the age of 50. They are concerned about how to maintain their lifestyle during the next phase of life and not running out of money. It is imperative that they have an intellectual understanding and an emotional acceptance of the risk associated with their investment portfolio in order to avoid costly errors. While there are many different risks associated with investing, we believe a sound starting point to understanding risk is to first understand what your overall asset allocation is. Simply stated your asset allocation is how your portfolio is invested proportionally in stocks, bonds, and cash. Knowing your portfolio’s percentage of stocks/bonds/cash will enable you to draw fairly clear expectations around how your investments may perform in down markets. Why is this knowledge so important? Because our experience working with clients has been that when they understand and accept the level of risk associated with their portfolio, they tend to make much better investment decisions when markets turn downward—ultimately leading to better results!
Our experience and academic research proves that investors can be their own worst enemies, often chasing performance (increasing risk) when markets rise, and making fear-based decisions to sell into falling markets—at the worse time. A study by Vanguard says that this reactionary behavior costs investors as much as 1.5 percent over time*. On the surface 1.5 percent may not sound like a lot but compounded over time it adds up to be a significant difference.
If you e-mail me I will send you our risk/return matrix, compiled using data from Morningstar/Ibbotson. You will be able to understand the risk level associated with various stock/bond allocations. The column you will want to pay attention to is the far right column titled “historical range 1926-2013.” Now let’s assume that you’re invested in a 60 percent stock/40 percent bond portfolio, # 4 on the chart. What the matrix is telling you is that during a typical bad year in financial markets your portfolio will decline by 7.02 percent; in really challenging years your portfolio can decline an additional 7 to 14 percent, for a market adjustment downwards of 21%. And, while no one likes seeing the value of their portfolio decline by more than 20 percent, it’s important to know your tolerance for risk. The questions that need to be addressed by the educated investor are:
When my portfolio declines somewhere between 7 to 21 percent, what does it mean to me economically?
More importantly what is my likely reaction? Will I sell (locking in those losses) or will I stick to my long-term investment strategy?
Knowing the answers to these questions can have a tremendous impact on your long-term investment results. We always advise clients to make an informed decision to reduce their risk until it is at a point where they feel confident that they can follow their long-term investment strategy! Finally, you can e-mail me at jdisalvo@nullquestcapital.mgmt.com and I will be happy to send you our risk/return matrix.