Do you understand how risk is being managed in your investment portfolio? It has been my experience that most people do not understand the risk they are taking in their investment portfolio. They turn over the management responsibilities to an “advisor” that they assume is doing the right thing for them. This was again highlighted when I met with a prospective client. I wanted to share some thoughts that I hope can help you better understand the risks you may be taking in your investment portfolio.
There are many kinds of financial risks we face. A few of those include dying to soon, living to long, inflation, stock market volatility, sequence of returns, making bad decisions, or paying too much in taxes. The risk I would like to discuss today is your risk tolerance.
Risk tolerance is the amount of loss you are willing to see in your portfolio before you will want to FREAK OUT. Did you stop opening your statements in 2008, because you didn’t want to see what they said? That’s FREAKING OUT! Most people I talk to would define their risk level as Moderate. I think a lot of that comes from being in the middle feels comfortable, not really how much risk they are willing to take. So, what does that mean for your portfolio, in a year like 2008 you might be down 20-30% for a Moderate portfolio. Let’s put that into dollar terms if you started with $500,000 you would be down to $350-400,000.
So, back to my meeting with this prospective client, we reviewed the portfolio that another advisory firm had set up for them. Their portfolio consisted of several stock mutual funds and a handful of individual stocks. I asked them what they felt their risk level is, to which they replied Moderate. I indicated to them that a typical Moderate portfolio would consist of 60% stocks 40% bonds, and their portfolio is currently 100% stocks/ stock mutual funds. By the way, I am not a fan of the typical 60/40 portfolio, but that is a conversation for another day. I was merely trying to indicate that for a Moderate investor 100% stocks is to aggressive. I then proceeded with a follow-up question. What if your $130,000 portfolio was down to $75,000? After they gasped, they said that would scare them. I informed them that an all equity portfolio like they have could have been down that much or more in 2008. I then said what if you were down to $100,000? They said that would still be a significant loss. I told them that this allocation has probably helped them do very well over the last several years because stocks have done very well, but this portfolio may not be the best for them. I told them that based on their reactions that they should consider a reallocation of their portfolio to be more in line with the level of risk they are willing to accept. The moderate to conservative moderate portfolio probably would not have provided as high of returns the last couple of years as their current portfolio, but it would be more appropriate for them.
Being overly aggressive causes many investors to perform poorly. Taking on too much risk can cause someone to want to sell after they have reached their pain point, which can make it very difficult to recover. They would have been better off by just taking an appropriate amount of risk in the first place. I would encourage you to check out The Tale of Two Investors which talks about why taking more risk is not always better.
The stock market has been doing well over the last several years, now may be a good time to take another look at your portfolio. It is important to understand how it will react in different market environments. If you have any questions or would like to review your portfolio, please feel free to reach out to me.