Let Me Clarify
Perhaps the biggest struggle for investors, that I’ve witnessed, has been truly understanding the concept of risk. Of course, we all understand that “risk” in its purest form means that bad things can happen. But, much of the investing population still has a hard time taking a step back to really understand the rationality, discipline, and self-awareness that is necessary.
Let me clarify.
Markets are anything but rational. I mean, think about March 26th, when the U.S market rose some 6% despite an exponentially growing Coronavirus, an economy that was “shut down” for the time being, and the report of the largest amount of jobless claims in U.S. history. Sure, there was a whiff of a stimulus bill that was up for approval, but even that was speculation and hadn’t actually been approved yet.
I say all of this, not to pretend that I have any clue as to what will happen day to day with the market (just like not a single other person does), but I say this as an example of how unjustifiably volatile our markets can be. Yes, in this example the market rallied, but as February 19th through March 23rd has shown us, things can swing in the negative direction just as quickly.
So, with markets being so unpredictable, what can investors do?
Quick answer: Control what you can actually control.
Aside from spending needs (to a degree), the risk within your portfolio is one of the major aspects that you have at least some control over. Again, there are no guarantees and nothing to say that what has happened historically is an exact indicator of what will happen in the future, but there’s something to be said of the impact of diversification and the allocation within an investment portfolio.
I’m sure that most of you, at one point of another, have taken a risk tolerance assessment (If you never have, you probably should!). And that’s a great start. However, like I mentioned at the beginning, there is often a failure to truly understand the concept of “risk” within that context. Let’s approach this from the perspectives of risk tolerance and risk capacity, the two common components to the assessments.
Risk tolerance: Risk “tolerance” focuses primarily on an investor’s personality and feelings. An example might be “what would you do if your investments had dropped xx% in one month?” These are great questions to be asked, but the issues I’ve noticed are 1.) these specific questions only focus on personality and not the realities of the dollars and cents within the investor’s situation and 2.) most investors approach this based on how they feel at that very moment, as opposed to approaching it rationally. Let’s take a look at each part on its own:
- If somebody has $100,000 saved and needs to take out $10,000 per year for the next 10 years, do you think he or she can afford to lose 50% of the account during a collapse in the market? My hope is that you said “no” even before I told you that they are a self-proclaimed aggressive investor. The facts matter more than just how much of a gambler that person has been in their lifetime.
- It’s pretty common for there to be a disconnect between feelings on paper and feelings in reality. How many investors do you think, on paper, say that they would buy more if the market had a quick drop? How many people do you think actually do that when the opportunity presents itself? I don’t have an exact number, but I promise you that not everyone who says they would actually do. On paper it sounds great (the whole premise of investing is to buy at lows and sell at highs), but think about that actual feeling you might have in your stomach when you’re faced with putting additional money into a losing market, that may already be down 30+%. You certainly are not alone, if you wouldn’t be able to pull the trigger.
Let’s put ourselves in a retiree’s shoes.
Risk capacity: Risk capacity focuses on the other side of the equation; that being the facts. This would include your age, withdrawal needs, time horizon, etc. Again, this is extremely important information to have, but can backfire if it is the only focus of the conversation. Most notably might be an investor who is simply told to take as much risk as they can because of their young age, or not having enough saved to meet their goal. What happens when the market dives and the account value with it? If the conservative nature of the investor’s personality was not taken into consideration, its likely that he or she may panic after seeing a large loss and choose to sell, abandoning the emotionless plan. In this case, they ended up doing the exact opposite of basic investing principals; sold out at a low and may not reenter in the near future, putting them in a worse position than where they began.
My point in all of this is not to downplay the importance of risk tolerance assessments and exercises. In fact, I think they are pivotal, but mainly when used correctly! What that means, is that when you are creating a plan for investing, it is imperative that you are honest with yourself about the emotions you would likely have in different market environments, the discipline you would have in sticking with the plan you decide on, and your overall understanding to remaining focused on the items you actually have control over.
Why do you think most investors underperform even a basic 60% stock/40% bond portfolio? Well, When markets are doing well and everyone is a self-proclaimed “aggressive investor”, they buy buy buy. And, after markets have dropped and those same individuals are then self-described “conservative investors”, they sell sell sell.
February through March alone was perhaps the biggest test that we have faced in over 11 years, as investors. This time has tested how true we were to ourselves during portfolio reviews, risk tolerance exercises, and other investments decision that we made. Many investors wait until it is too late to avoid making unnecessary mistakes (after having bought at the highs, they then panic sold at lows). However, I urge you that now is as good a time as ever to review your risk with your advisor; and especially with yourself.
As we embark on this clarifying journey together, I encourage you to submit any ideas, topics, or questions to firstname.lastname@example.org. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. “Let Me Clarify” is a weekly blog containing Chad Baxter’s insights and thoughts about a variety of topics. To learn more about Chad, click here
All performance referenced is historical and no guarantee of future results. All investing involves risk including loss of principal. No strategy assures success or protects against loss. This information is not intended to be a substitute for individualized legal advice. Please consult your legal advisor regarding your specific situation. Clarify Wealth Management and LPL Financial do not provide legal advice or services. 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 investing involves risk including loss of principal. 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. Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.