Can you really “live with the risk”?
In this day and age of “robo-advisors” and passive index investing, many investors seem to have forgotten the single immutable truth that equity markets are inherently risky. That’s simply because the share prices of stocks traded on markets are influenced mostly by expectations of future earnings growth. Many factors can come to bear on these expectations apart from a company’s competitive position, financial strength, and industry outlook. These include shorter-term geopolitical events (not as important) and longer-term economic and monetary policies (more important). Put it all together and it adds up to market-wide trends, oscillations, and fluctuations, which are often characterized by a wide amplitude from top to bottom. This is what’s broadly called “risk.” And it’s what most investors have trouble dealing with.
Many investors, particularly novice investors, have a wildly inflated sense of their tolerance for risk. I’m often asked why not allocate 100% to stocks when markets are making new highs? I’ve lost count of the number of times I’ve heard the phrase, “I can live with the risk.” But can you really? A high net worth portfolio of, say $500,000, invested in a broad equity index ETF would plunge by $60,000 dollars if the market sustains a 12% correction. Your portfolio would have to climb 13.6% just to get back to breakeven – a climb that usually takes much longer than the initial drop. Could you really live with that kind of fluctuation?
The key to dealing with risk is to ensure that your investment portfolio aligns with your tolerance for risk. With moderate risk-tolerance, for example, you might weight your portfolio 60% equity and 40% fixed income. The equity component is there to generate longer-term growth (and perhaps some dividend income); the fixed-income allocation is for safety and income.
Remember that when you create an investment strategy, you’re doing it with the objective of increasing your wealth. But you want to do that while staying in your risk comfort zone.
So if you’ve decided, say, that you are a more defensive, low-risk investor, but you still like the idea of some growth, then you might settle on a broadly diversified asset mix of perhaps 10% cash, 50% fixed-income, and 40% conservative dividend-paying stocks.
That sort of portfolio allocation will serve you well, but you have to maintain the discipline to stay with it. Your equities will fluctuate more than your fixed-income and cash. But that’s the point: Your fixed-income bonds and dividend-payers are designed as a kind of built-in risk-reduction function, so your overall portfolio won’t suffer as much in those inevitable market downturns.
But whatever strategy you’ve decided upon at the outset, you have to stick to it to make it work. The discipline lies in making sure you don’t re-set your portfolio at every turn of the market or every piece of hysterical hype emanating from social media – because you’ll almost certainly do it at the wrong time.
Investing takes knowledge and patience. Know your own risk tolerance and be realistic about it. Stay educated and make decisions only when you have weighed the pros and cons and are ready to be accountable for the outcome. If you are not sure you are holding the right asset mix, or are uncertain about your true tolerance for risk, consult a qualified financial advisor, who can meet with you personally and who is equipped to help you with precisely those problems.
© 2018 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.