I’ve dealt with the concept of risk every day for more than 30 years. When I work with a client on their financial planning and managing their wealth, it’s amazing how everyone seems to love to take risks when the financial markets are rising, and then it’s equally amazing how quickly they become conservative when markets decline. Managing risk is really a matter of walking a fine line between fear and greed. So during times of market shocks, it's especially important to control one’s emotions and think logically about your financial goals.
Many market shocks are short-lived, once investors conclude the event is unlikely to cause lasting economic damage. Still, major market downturns, such as the 2000 dot-com bust and the 2008-09 credit crisis, are powerful reminders that we cannot control or predict exactly how, where, or when precarious situations will arise.
Market risk refers to the possibility that an investment will lose value because of a broad decline in the financial markets, which can be the result of economic or political factors. Investors who are willing to accept more investment risk may benefit from higher returns in the good times, but they also get hit harder during the bad times. A more conservative portfolio generally means there are fewer highs, but also fewer lows.
Your portfolio's risk profile should reflect your ability to endure periods of market volatility, both financially and emotionally. Here are some questions that may help you evaluate your personal relationship with financial risk.
How much risk can you afford?
Your capacity for risk generally depends on your current financial position (income, assets, and expenses) as well as your age, health, future earning potential, and time horizon. What is time horizon, you may ask? Your time horizon is the length of time before you expect to tap your investment assets for specific financial goals; retirement, college savings, etc. The more time you have to keep the money invested, the more likely it is that you can ride out the volatility associated with riskier investments. For instance, an aggressive risk profile may be appropriate if you're investing for a retirement that is many years away. However, investing for a teenager's upcoming college education may call for a conservative approach.
How much risk may be needed to meet your goals?
Basically, if you know how much money you have to invest and can estimate how much you will need in the future, then it's possible to calculate a "required return" (and a corresponding level of risk) for your investments. Older retirees who have sufficient income and assets to cover expenses for the rest of their lives may not need to expose their savings to additional financial risk. On the other hand, some risk-averse individuals may need to invest more aggressively to accumulate enough money for retirement and offset other risks such as inflation which could erode the purchasing power of their assets over the long term.
If, after reviewing your financial plan, you find yourself in the uncomfortable position of not having enough money at retirement because you took minimal financial risk, you may have to come to grips with the fact that you’ll need to work longer.
How much risk are you comfortable taking?
An investor's true psychological risk tolerance can be difficult to assess; some people seem to be born risk-takers, whereas others are cautious by nature. Some people who describe their personality a certain way on a questionnaire may act differently when they are tested by real events. Recently, a new client came to Brighton Wealth Management and after preparing a financial plan, it seemed that he was aggressive in his financial risk-taking. He had $5 million dollars to invest. Before investing one dime, I asked him how he would feel if he received a statement that showed his investments had declined by $500,000. He almost fell off of his chair. That is a 10% decline and an aggressively invested account certainly has the capability to decline by that amount at any time. By asking the question, using real dollars and not percentages, it made it much more realistic for the client. In the end, we approached his financial situation with a more conservative stance.
Keep in mind, an investor's attitude toward risk can change over time with experience and age. New investors may be more fearful of potential losses than more experienced investors who have weathered the cyclical and ever-changing nature of the economy and investment performance, and who may be more comfortable with short-term market swings.
Financial market declines are an inevitable part of investing, but abandoning a sound investment strategy in the heat of the moment could be detrimental to your portfolio's long-term performance. One thing you can do to strengthen your mindset is to anticipate some scenarios in which the value of your investments were to fall by 20% to 40%, and convert the percentages to real dollars. If you become overly anxious about the possibility of such a loss (as in the example above), it might be helpful to reduce the level of risk in your financial portfolio. Otherwise, having a plan in place could help you manage your emotions when turbulent times arrive. Using different strategies that could help take your emotions out of the equation would be a great help and can lead to a more successful outcome. By the way, watching the news is not a good strategy!
Alan Battles is a Salt Lake City, Utah fee-only Registered Investment Advisor (RIA) fiduciary and financial planner. Brighton Wealth Management, Inc. specializes in providing objective financial planning and investment management to help clients build, manage, grow, and organize their assets during life’s transitions.
All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy will be successful.
The information in this material is not intended as investment, tax, or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.