Get a fix on your true level of risk tolerance
Until very recently, things had been looking up in the U.S. The Labor Department reported that the U.S. unemployment rate dropped to 11.1% in June, as millions of Americans began returning to work. That helped lift investor sentiment on hopes that the economy would start to recover. But a resurgence in COVID-19 cases in the U.S. over the past couple of weeks could derail that. This past week, over 77,000 new COVID-19 cases were reported in the U.S. in a single day.
In Canada, the situation has stabilized, with a general downtrend in new COVID-19 cases across the country. Provincial governments have been gradually easing restrictions, while continuing to test for COVID-19 and watching trend lines closely.
The S&P 500 Composite Index advanced 1.8% in June, for a gain of nearly 20% in the second quarter. But the index is still posting a 3.1% loss for the year to date as of June 30.
The Nasdaq Composite Index, which is home to some of the tech giants like Amazon.com Inc., Netflix Inc., and Apple Corp. rose 30.6% in the second quarter and is ahead 13.8% for the year to date to June 30.
Toronto’s S&P/TSX Composite Index largely followed the U.S. stock market indexes, and because of its heavy resource weighting, got a boost from the rising price of crude oil and gained 16% in the second quarter. But the index still posted a year-to-date loss of 8.6% loss, as Statistics Canada reported a 17.1% year-over-year decline in Canada’s GDP in April, with only a small 3% recovery expected in May.
Central banks continue their programs of quantitative easing (buying bonds), as policy interest rates remain at 0.25% in an effort to provide liquidity. Governments have opened up the fiscal taps to provide financial relief to individuals and businesses affected by the COVID-19 lockdowns. In Canada the government deficit has ballooned to $340 billion – and projected to climb as the economy stays in deep recession for the rest of the year. The government estimates that GDP will shrink 6.8% this year, the largest contraction on record, according to the Fraser Institute, while unemployment is projected at 9.8% this year. The government’s “Fiscal Snapshot” delivered July 8 also projects that federal debt will exceed $1 trillion.
This has helped stabilize markets somewhat in the short term, and while the second quarter saw an impressive rally, the big stock indexes have been largely flat over the past couple of weeks, moving in a fairly narrow trading range with no major dips or spikes. Investors appear to be marking time, assessing whether a second wave of COVID-19 is looming, and whether a major lockdowns will be reinstated in the fall, extending the economic recession until the end of the year and beyond.
Testing risk tolerance
Many investors, particularly novice investors, have had their personal risk tolerance tested severely over the past couple of months. A year ago, when the market was surging, equity investors felt they could not go wrong. At times like that, advisors frequently hear the phrase, “I can live with the risk.” But can you really? That was put to the test with the advent of the COVID-19 pandemic.
A high net worth portfolio of, say, $500,000, invested in a broad all-equity index ETF would have plunged by as much as $160,000 as markets crashed this past February and March. In fact, in a four-week period from Feb. 19 to March 23, the S&P 500 Composite Index dropped close to 35%, while the S&P/TSX Composite fell 32%. Can you really live with a loss of $160,000 in your $500,000 all-equity portfolio? Many overconfident investors found out. And, remember, your portfolio would have to climb 47% just to get back to breakeven – a climb that usually takes much longer than the initial drop.
So how do you deal with the issue of false risk tolerance? The key is to ensure that your investment portfolio aligns with your true tolerance for risk. When your advisor first asks you whether you are comfortable losing 10%, 20%, or 30% of your portfolio’s value due to a sudden drop in markets, they’re not just playing a game of “let’s pretend.” Put it in specific terms. Take the full value of your portfolio across all accounts and apply the percentage drop to it. That way, you’ll get a precise dollar value of your loss. As amply demonstrated over the past few weeks, if you admit to a high tolerance for risk, able to withstand a 30% decline in portfolio value, that amounts to a $150,000 loss in a $500,000 portfolio. Think about it long and hard.
Build portfolios on a solid foundation
Your true risk tolerance will dictate the construction of your portfolio. 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. The strategy can be seen in a balanced portfolio like iShares Core Conservative Balanced ETF Portfolio (XCNS:TSX), which lost 17% in the February to March market crash, compared with the 35% loss for the S&P 500.
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.
A properly diversified portfolio allocation directed by your true tolerance for risk 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.
Stick to your plan
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.
© 2020 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.