Risk, Portfolios and Plans
Most financial decisions involve some degree of risk. While investing in capital markets has the risk of losses, not investing has the risk of missing an opportunity for a return on your investment. We have addressed systematic and non-systematic risk in previous blog posts, but in this case, we’re talking about emotional risk tolerance. One’s emotional comfort level with investment risk is a personal decision unique to the individual. Additionally, unlike, say, height or weight, there is no unit of measurement for risk tolerance. What I might consider a “safe bet,” you might perceive as highly risky.
Investment risk also falls into its own category. Just because you enjoy driving motorcycles and skydiving, does not mean you are comfortable with high-risk investments. Another separate but related factor is risk capacity. This is the amount of risk you can take versus the amount you are comfortable taking. A 20-year old’s ability to take on risk might be very different from someone who is a year away from retirement.
One of the many benefits of having a comprehensive financial plan is understanding the role of your portfolio and the subsequent relationship between risk and return. When evaluating a portfolio, most investors consider the average long-term return and set their expectations around that number. For example, between 1988 - 2016 the Russell 3000, an index that tracks the performance of the 3,000 largest U.S.-traded stocks, returned, on average, just under 9.5% per year. However, it never actually returned anything in the 9% range. In fact, a return of between 7-12% only occurred 5 times in this 29-year time period. Understanding investment risk tolerance is less about how much total return you want, and more about how much short-term volatility you can stomach while sticking to your initial strategy. An average of 9.5% sounds great, but how will you respond to repeated double-digit losses?
A comprehensive financial plan allows us to conceptualize how a long-term strategy can help you reach your financial goals. The planning process moves beyond focusing exclusively on a portfolio's average return. Instead, a plan outlines how returns can be a moving target and our analysis helps direct you to the sweet spot between maximizing your investment risk while minimizing your exposure to unnecessary volatility.
Many investors who are near or in retirement are surprised to see that scaling back their investment risk, and the return associated with it actually increases their chances of a successful retirement. This is because once a portfolio is forced to produce income, there is a greater risk of having to take withdrawals during down years. We call this “sequence of return risk,” and you can read more about this in an earlier blog posted here. A financial plan can show that less risk and return is okay, as long as there is less anticipated volatility from year to year.