Welcome to the latest blog from 7th Street Financial where I discuss various topics related to personal finance with the goal of providing insight you can use for yourself or at the very least get you thinking about certain topics and how they might impact you.
In this first of two installments on the topic, I will discuss risk management within your investment portfolio. The two primary key concepts covered here will be Risk Tolerance and Risk Capacity. These two items combined help us determine the proper allocation of one’s portfolio. The second installment will cover the risk elements that drive to having proper diversification within the portfolio.
One of the primary tenants of investing is risk vs. reward. In order for us to get larger returns on our investments we need to take larger risks. Historically, the larger share of your investments that are in equities the better your long term return. Equities though tend to be more risky than fixed income investments from the perspective that they are more prone to sharp declines. This risk of holding equities smooths out over the long term as short term ups and down tend to result in a long term upward trajectory. The following two charts show year by year returns for the S&P 500 which highlights that there is occasional downside risk while most years are positive and the second chart is the historical long term trend which reflects long term growth. Managing the risk of short term declines can be critical depending upon where you are at in your investing lifecycle.
Many of us are at least somewhat familiar with the concept of Risk Tolerance which is basically a measure of how much risk are you comfortable having in your portfolio. As an advisor, I use a series of questions that I pose to clients to determine their appetite for incurring risk. These questions are geared to help an advisor understand how comfortable someone is with investments, their mindset with investing, and how you would react to several potential investment return scenarios. For example, a question might be “if the stock market is down 25%, what would you do?” and the options would be something like 1. Buy more; 2. Stay the course; 3. Sell some of the investments; 4. Sell all of the investments. The person who sees this as an opportunity to buy more is demonstrating a high risk tolerance where the person inclined to sell is not.
This is something that needs be continually monitored. Life experiences and situations may change the way an investor feels about risk. It is one thing to answer a theoretical situation on paper but it is another to see you IRA drop by 30%. People have a tendency to be slightly more conservative in real life than on paper.
The goal with this series of questions is to have the information needed to construct a portfolio for the investor that they can be comfortable with. One key to know as the investor is that the most important thing is to just be truthful in your responses. Advisors shouldn’t care if you profile out as more conservative or aggressive. There is no right or wrong on that scale. The advisor should just want to do what is right for you. If an advisor pressures you into a portfolio you are not comfortable with that is a warning sign you and the advisor are probably not a good fit. The last thing I want is for a client to be losing sleep at night because they can’t handle the ups and downs of a turbulent market.
Risk tolerance is a measure of an investor’s ability psychological ability to handle risk. There are no neat categories that groups of people fit in. Younger investors can be just as conservative with risk as older investors and vice versa.
In addition to Risk Tolerance, advisors also consider a lesser known concept known as Risk Capacity. This is a measure of the amount of risk an investor can take on to achieve their goals and may or may not line up with your Risk Tolerance. Also, you may have different Risk Capacities for different financial goals. The basic measurement of one’s Risk Capacity is time. The longer you have before you need the money for a given goal the higher your Risk Capacity is and as your time horizon shortens before you need money the lower your Risk Capacity becomes.
For example, when you are age 30 and saving for retirement you have a very high Risk Capacity as you have potentially 30 plus years to grow your investments and plenty of time to ride out any ups and downs in your returns. Compare that to when you are three years away from retirement and you no longer have time to recover from a major market downturn which results in you having a very low Risk Capacity.
As I stated earlier, you might have different Risk Capacities for different financial goals. I found myself in this position this past year. Take a couple who is 50 years old planning to retire at age 62 with a 16 year old child. Since they have 12 years to go to retirement they still have a fairy high risk capacity in terms of retirement but if they have been saving for their child to go to college they have a very low risk capacity for those funds as they would have almost no time to recover from a market downturn. As a result, I left my retirement funds alone but moved the funds in our 529 plan to a much more conservative investment in 2019 when we were two years out from needing the funds. At that point I was less concerned with trying to get substantial growth than protecting what we had already saved and was willing to take a much lower return in exchange. When Covid-19 hit my retirement funds certainly took a hit but they have time to recover but our 529 plan just took a minor dip which, thankfully, was not enough to alter our plans. Events like Covid-19, the Financial Crisis of 2008 are why we make these moves to get more conservative as our time horizon gets closer.
Next, what do you do if your risk capacity and risk tolerance are at odds with each other? Take the situation I discussed above with our college savings. My risk tolerance is fairly high but our risk capacity was low due to our short time horizon. When it comes to risk management with your investments choose the more conservative option in a case like this so even though risk tolerance is high the low risk capacity wins out.
The same holds true in the case of a low risk tolerance and high risk capacity. This might happen if there is a 30 year old who has decades to save for retirement but gets nervous when there is volatility in the market. Even though there is plenty of time to recover from any downturns I don’t want the client to be uncomfortable watching the daily ups and downs if that makes them uncomfortable. A slightly more conservative portfolio makes sense in this case.
The combination of Risk Tolerance and Risk Capacity drives the proper allocation in an investor’s portfolio. You are probably familiar with people talking about a 70/30 or 60/40 mix or something similar. That is in reference to the allocation of equity versus fixed income holdings in a portfolio with a 70/30 meaning 70% of the portfolio is in equities and 30% in fixed income. The higher the equity holdings the riskier the portfolio.
So, let’s put everything together and walk through a couple of examples. Say we have our 30 year old and their retirement savings. They have moderate risk tolerance and high rick capacity at this stage of their life which might put them in a 70/30 portfolio for now. As they get within 10 years of retirement they can start to gradually become more conservative. By the time they hit retirement a 50/50 portfolio may be appropriate. This is similar to the approach I took with the 529 plan I mentioned earlier. When our daughter was born the portfolio was nearly 100% equities. Since the entire life of the investment is only 18 years we moved through the stages much quicker. By age 10, the portfolio mix was closer to 70/30, by age 13 it was closer to 60/40 and at age 16 it was 40/60.
Remember that as an investor there is no right or wrong answer for where you land on the spectrum. Over the long term a higher equity allocation historically has resulted in higher returns but that may not be worth the mental anxiety or the risk of short term downturns for you. If your allocation isn’t the same as your family, friends or that is okay. You need your portfolio to work for you and your goals which are unique to you.
That wraps up this first installment on portfolio risk management. I hope you found this informative and maybe learned something you can use for yourself. Look for the next installment portfolio risk management where I will cover diversification.
If you have any questions about where you should be from an allocation standpoint and if your portfolio is properly matched feel free to reach out to firstname.lastname@example.org or visit our website at www.7thstfinancial.com to schedule a no cost 30 minute discussion on your situation.
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