Risk Taking, Financial Planning, Expectations and Behavior
If you have ever worked with me as a client, you know that I’m constantly talking about risk. There’s a reason for that. Risk is probably going to be one of the largest determining factors in whether you reach your financial goals. Don’t take enough and you won’t get the returns you need to retire or reach those goals. Take too much and you run the risk of your portfolio taking too many losses at the wrong times and your financial plan essentially “blowing up”.
Let’s break this down. There’s three ways I look at risk as a Investment Adviser and Investor.
1) Risk with regards to investment returns
2) Risk with regards to a Financial Plan
3) Risk with regards to behavior.
All are super important and frankly tie together like the ingredients in a recipe.
Let’s start with what risk is.
In my world, I refer to real investment risk as “Drawdown”. This is simply the maximum loss you have ever experienced from your peak portfolio value swinging down to your lowest portfolio valueYou’ll hear investment risk referred to in other ways, but this is the number that actually counts. If your portfolio drops from $500,000 to $250,000, that’s a 50% loss or “drawdown” and that is going to have a major effect on your financial plan. The real question is can you handle that 50% loss - both from a financial planning standpoint and from an emotional standpoint?
Now we’ve all heard the old axiom “the more risk, the more reward”. This is true in a lot of aspects of life, but with investing…it doesn’t always play out that way. This is due to time frame. If you’re ever worked with me, you’ve probably seen the opening image to this article. This killer chart shows the returns of the U.S. stock market (represented by the S&P 500) going back 120+ years.
There are numerous periods of time in our history where the U.S. stock market went 10-15 years earning next to nothing. So do you get more return for taking more risk? If we’re looking over 100+ years, then historically yes. But we don’t invest for 100 years. If you’re lucky, you’ve got 30-35 years to save/invest for retirement. When you push your investing time horizon down to 30 years, you now have numerous times in history where you could have taken a lot of risk and made nothing on your money. You can’t afford to have 10 or 15 years out of your 30 give you a nothing in return. You can’t make up that kind of time.
Financial Plan Risk
Knowing the potential risk in your investments, what kind of risk should you take with respect to your Financial Plan?
What do you need to reach your goals and what can you handle?
When I work with clients on their plan, the first thing we figure out is what risk they need to take in order to potentially make their goals happen. Any risk level beyond that is a personal choice. If you only need 6.5% annualized return to make your retirement possible at age 60, then we need to build a portfolio that can give you that. If you need 8% return, then we build a portfolio that has the potential for that. There’s no need to take risk beyond that unless you want it, understand it, and are willing to take responsibility for the potential outcome.
What this means is - at what point are you going to panic and do something with your portfolio that is counter to achieving the plan we’ve just built? At what potential loss are you going to call us and sell everything out of fear?
Or from another perspective - at what point are you going to call and say your portfolio isn’t making enough compared to the S&P 500 Index, the Dow Jones, or the NASDAQ? Then sell your investments and hop to another Financial Adviser/Firm to try and get the investment returns you “think” you should be getting?
I’m not saying you should stay with an Adviser who is under-performing year after year. What I am saying is you need to have a good understanding of the approach your Financial Adviser is going to use to invest your assets to make the plan he/she should have done for you work!
Your Adviser should be setting realistic expectations for you and should provide you with a pretty good idea of how and why his or her investment approach should work. And he/she should have some method to help them understand what your tolerance for risk actually is (from a behavioral standpoint).
How Do You Think About Risk?
It’s easy to start thinking about how you view risk. Simply click here to answer a few questions. At the end of these questions a portfolio that best meets your risk profile will be created. This is the first step we use with clients.
Give it a try!