Lineweaver Financial Group
Monitoring Risk in a Volatile Market
Determine Your Need for Risk
Many individuals will claim they are adverse to a high level of risk, while others embrace it and feel that a long-term strategy can make up for any short-term losses. However, it is still prudent to try to mitigate and control risk at all stages in an attempt to manage your long-term returns. I think "risk" is the most widely misunderstood investment concept. The consequences can be dire—running out of money before you run out of time. My favorite framework for thinking about risk looks at risk in three ways: your willingness, your ability, and your need to take risk. Most individuals can measure their willingness and ability for risk, but few factor their actual need to take on an appropriate level of risk.
Risk is often defined as the odds of losing money or the chance of getting a return different from that which you expect. Against this backdrop many individuals—understandably—focus on their willingness to endure "risk." Others will focus on their ability to take risk. These investors will ask themselves if, given their age, income or profession, they have enough time, future earnings or job stability to stomach risk.
But the question that I don't hear asked nearly enough is whether or not one needs to take risk. For example, take a 65-year-old retired police officer with an investment portfolio and no debt maintaining an all-equity portfolio. His living expenses are more than fully covered by his pension, required minimum distributions, and his reduced Social Security benefit. In this case the "need" to take excessive risk is not there even if the willingness is. On the other end of the spectrum is the 22-year-old new hire Patrolman who elects to put his entire 457(b) in a stable or fixed fund. In this case, the willingness to take risk is absent but the need for "risk," in the face of potential long run inflation, would be high. In both scenarios, they did not consider what their need for risk should be.
Everyone’s comfort level of risk can be different, and the outcome of performance is likely to be affected by that level. However, with proper diversification and active management of your portfolio, there are ways to control and alleviate your level of risk, while still allowing for potential returns that can meet your long-term goals. Having a well structured, diversified portfolio is a prudent way to help manage your risk level. Some people prefer to have professionals manage their account for them, so it takes the emotion out of the decision making. This can help prevent the “panic sell”, which may turn into a “buy high and sell low strategy”.
So how does the typical investor’s returns compare to some of the major market indices over the past 20 years? To make it very simple, the S&P 500 averaged 7.8% per year, while the Barclays Capital US Aggregate Bond Index returned 6.5% per year over the same time period. A 50/50 blend of these two asset classes would have yielded a nominal annualized return of 7.2%.
However, the average investor's 20 year annualized return is dismal compared to those figures. According to an analysis by Dalbar, the average investor earned 2.1% over the twenty year period ended Dec. 31, 2011. But wait, it gets even worse. After including inflation, the average investor actually got a negative real return. Inflation (CPI) grew at an annualized rate of 2.5% during that same period. So the average investors' net real return was -0.4%. The average investor is not very good at capturing the market return of a simple balanced portfolio, never mind outperforming it.
As you can see, many investors make decisions based on “short-term concerns, crowding out longer-term, more rational strategies,” and are overly influenced by the daily noise about stocks in the media. By taking emotion out of the equation, you are more likely to benefit from a "Buy low, sell high” strategy. Note that that phrase does not call for buying at the "lowest" or selling at the "highest," which is, of course, impossible to do on a consistent basis. It simply recommends a process of harvesting those holdings that have done well, and reseeding a portfolio with holdings that have underperformed. This, essentially, is what rebalancing a portfolio is all about: a prudent strategy for managing an investor's overall risk. Most people think that "buying low and selling high" is the magic formula for above-average returns, but in fact it is a strategy for managing portfolio risk and many individuals aren’t able to do this by themselves.
While risk and reward go hand in hand, it's important to think about all three elements of risk—your willingness, ability, and need to take risk—before making investment decisions. If after reviewing your current portfolio or level of risk you have questions, feel free to give us a call.
Lineweaver Financial Group s 9035 Sweet Valley Drive s Valley View, OH 44125 s 216.520.1711
Securities offered through Sigma Financial Corporation. Member FINRA/SIPC.
Lineweaver Financial Group is independently owned and operated.
It is not possible to invest directly in an index. Diversification and asset allocation does not guarantee against loss or ensure a profit. They are methods used to help manage risk.