How risky is your investment portfolio? And, what is risk anyway? Investopedia defines it as “the chance an investment’s actual return will differ from the expected return. Risk includes the possibility of losing some or all of the original investment.” (Keep reading—at the end of this piece I’m going to explain why you really need to look at this differently.)
A key term within that definition is “expected return.” If your idea of expected return is “Whatever the DOW is getting,” I think you’ll be sadly disappointed—unless your portfolio is invested in the DOW. Said another way, if you hear on the news that the DOW is up 10% year-to-date, you cannot expect that your portfolio is also up 10% unless it is invested in the DOW. No professional money manager will invest your entire portfolio in the DOW. They will design a diversified portfolio of many, many stocks and bonds. Based on the mix of stocks and bonds, a custom, blended benchmark will be established for your portfolio. The benchmark is the expected return of your portfolio.
So, back to the definition of risk. I would modify it like this. . . risk is the chance that your investment’s actual return will differ from the assigned benchmark of your portfolio. And, that is where we can start evaluating your portfolio.
Our “New Client Application” has a question on it that addresses the prospective client’s investment expectations, where the client rates the relative importance of “I want my assets to keep pace with the stock market,” and “I want my assets to provide a guaranteed lifetime income.” It is interesting how many people rate them both as equally and highly important. Really, this is an either/or question; you can’t have both. Please keep reading—hopefully, this will become very clear.
It is also helpful to understand this: A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an investor is willing to take, the greater the potential return. Investors need to be compensated for taking on additional risk. For example, a U.S. Treasury bond is considered one of the safest, or risk-free, investments and when compared to a corporate bond, provides a lower rate of return. A corporation is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher, investors are offered a higher rate of return.
Along with higher returns, you get higher risk or volatility. Volatility, or the dispersion of returns around its average, is measured by standard deviation. The greater the standard deviation of a security, the greater the variance between each price and the mean, indicating a larger price range. For example, a volatile stock has a high standard deviation, while the deviation of a stable blue-chip stock is usually rather low.
Here is some data which may help clarify:
How much can my 60/40 moderate portfolio lose in a particular period? From the table you can see that the worst three year period resulted in a decline of -3.47%. (A whole lot better than DIA or SPY.) And, you should only be looking at periods of three years or longer. Shorter periods will give you false impressions of your investment strategy.
How would my 60/40 moderate portfolio react if the market crashed? From the table you can see that the horrible market crash of 2008 resulted in a decline of -29.05%—A whole lot better than DIA or SPY. (This does not take into consideration our firm’s use of “tilting” to limit declines.)
Is my 60/40 moderate portfolio diversified? From the table you can see that you have way, way more diversification than you would have by going with one of the popular indexes.
Am I being compensated for the risk I’m taking? From the table you can see that your risk/volatility level (9.82) is much lower than DIA or SPY. So, as would be expected, your increases are less, but so are your declines. You are being fairly compensated.
NOW, three important considerations:
#1 Risk isn’t so much a risk of loss, as it is a timing issue. Look at any major stock index over a long period of time and you will see that declines always come back. The real issue is, “Where will the market be when you need the money?” This is exactly why our firm manages this risk with our “tilting” methodology—to expand our opportunity in times of growth and reduce the down-side risk in times of market correction.
#2 You have more control of your “expected return” than you think. First, you need to get clear about what the expected return of YOUR portfolio is (not the S&P 500). Next, if your return is not what you want, then increase or decrease your risk to get the result you want.
#3 If we measure our investment success against the DOW or S&P 500, we’re using the wrong gauge. Seriously, and with all sincerity, beating the DOW or S&P 500 does not lead to peace of mind or personal fulfilment. We should measure our success against the accomplishment of our long-term hopes and dreams. If your financial plan says you can meet your objectives by averaging 6% return per year, that is what needs to happen. If your financial plan says you need a 23% return to meet your objectives, stressing out about beating the DOW still won’t help you accomplish your plan. You need to rethink your plan.
Case Study: In Chapter 2, of my book, Happy & Secure in Sonoma County, there is a client story about John and Amanda. They were worried about their financial situation and it was pulling them apart. This is what often happens when there is no financial plan in place. In my experience, some people fret about beating the market and some fret about running out of money. Neither are necessary, as I explained to John and Amanda. They just needed a plan. The plan our firm put together for them, helped them to stop worrying and start living. It really united them, gave them peace of mind and the ability to move forward to a fulfilling life. (If you haven’t read the book yet, you really should. You can call our office to get a copy.)
Let’s work together to increase your peace of mind and profit from a satisfying and fulfilling life.