How we handle risk and daily decisions from the amount of speed we choose to drive our car down the highway to swimming in the ocean, ziplining through Zimbabwe, or even just getting on a cruise ship or airplane for the next family vacation this summer are all examples of risk baked into our daily lives from the choices we make.
Economic, inflation and stock market forecasts are all over the place, just like world data points on the of COVID-19 pandemic and variants. While most people will recover from the Coronavirus or the flu on their own, they will still seek to remedy the situation with chicken noodle soup to over-the-counter meds after consulting “Dr. Google.” Cold and flu medications can help you to feel better while treating your symptoms, but do not provide a cure.
Our reactions to market crashes are much the same. We know that market volatility will eventually subside, but we feel compelled to take quick unnecessary (prescriptive type) action with our portfolios in the short term which may not greatly help the situation, if not make it worse.
Behavioral studies illustrate that for the 20 years ending December of 2019, the S&P 500 Index averaged just 6.06% a year while the average investor earned only 4.25%. This behavior “gap” is due to many usual suspects led by market timing and a poor assessment of one’s risk. Sometimes in life, “less may be better” like minimalism in music and art. To quote Gene Fama Jr., a famed economist, “Your money is like a bar of soap. The more you handle it, the less you’ll have.”
Assessment of risk
Risk tolerance can help you to decide specifically how much of your portfolio should be allocated to stocks vs bonds and cash and is the foundation of asset allocation. The recipe that is “right for you” based on your age, investment objectives and time frame can help to determine your target return goal each year (how much you want to earn), as well as determine a range of losses you are willing to accept when volatility spikes.
When you have a investment process in place as part of your Investment Policy Statement (IPS), your ongoing results are not completely random like the wild-west, but a bit more repeatable, controlled and consistent over time. “Over time” means over 2 to 5 years or more, not over 2 to 5 months. Investing is truly about your time “in the market” and not “timing the market.”
Many (if not most) boomer and retired investors that meet with us for the first time for a consultation claim how they are “highly risk adverse” and “don’t’ want to see half their savings lost in a crash.” Who does? Yet often times their portfolios do not match their risk profile or goals while being overweight stocks, cash, annuities and or other illiquid alternatives that are difficult to understand.
Managing your money to help meet your retirement and other long-term goals while assessing risk, should not involve emotions, darts, tarot cards or luck, like playing a roulette wheel in Vegas where the “odds are on the house,” but should involve a more controlled scientific approach to determining your willingness and ability to tolerate risk while taking control of your own results and financial future.
You can study all the maxims and investment risk rules of thumb (such as invest your age in bonds) till the cows come home, but there is no proven direct correlation between your “investment IQ” capabilities to whether you are in Mensa, graduated from an Ivy league college, or work as a surgeon or a Fortune 500 high tech engineer.
We have seen many advisors make incorrect assumptions on a client’s risk assessment because of age or career choice. We have many retired clients in their 70’s and 80’s who are invested in balanced 60/40 moderate-risk portfolios (stocks to bonds.) At the same time there are a few “Gen X” clients in their early 50’s who are more conservative, despite working in high-risk or high stress jobs such as commercial pilots and Emergency Medical Technicians.
In our opinion, investors continually make significant misperceptions of themselves and their ability to emotionally handle risk or shoot for more risky products and strategies to help greatly boost their income or returns due to greed or actual need. It seems that the smarter the person appears, the more likely they are to be overconfident with their risk-taking ability.
Having a misperception of your risk tolerance might also make you more vulnerable to scammers where you end up buying a complicated, high risk product from a less than scrupulous broker. Just the same, holding the majority of your 401(K) in company stock, while betting a good portion of your liquid savings on “hot” bitcoin, cannabis or tech start-up typed stocks is more speculative (Vegas) investing and not indicative of a wealth management process.
Investing should not be a competition with your friends and neighbors at a cocktail party or on Face Book. You may recall running into a friend or coworker bragging to everyone on how their investment product is providing a highly attractive annual yield, but not tell you when their strategy went up in smoke (literally) and lost half of principal in the past few months.
Jon here. We remind investors that it’s as important to consider the “return of your money” in as much the “return on your money” with each trade or purchase. My favorite four-letter word is EXIT. No matter whether purchasing investment property, art, watches, jewelry, an automobile, boat, crypto-coin or stock, always consider valuations and liquidity (ease and access to your investment when needed to cash out.)
Reliability of questionnaires
Your investment risk tolerance “DNA” is directly connected to your brain’s “pain threshold” to withstand market losses in extreme market conditions up to a certain point and not feel inclined to jump off the proverbial Wall Street rollercoaster while in motion.
A risk tolerance questionnaire can be a good start (albeit a very rough estimate) for investors to determine and target the appropriate levels of risk in their portfolios for relative values of expected returns over time in three vital areas:
To calculate these risks, we question whether investor risk questionnaires are helpful.
In our opinion, many computer-generated risk questionnaires have hokey questions with vague numerical outputs that sound more like a “sleep number” bed commercial than a reliable indicator of risk. It is sometimes just as difficult for advisors to just ask investors to benchmark their own risk tolerance because, as noted earlier, many of us are terrible at estimating our own risk and money management capabilities.
No matter what you may put down on a risk questionnaire, it’s only when the roller coaster turns sharply downward to 80 MPH after going up the hill 5 MPH (as we experienced in March of 2020) do we truly know our own colors. There is a saying that “stocks take the escalator up and the elevator down.” Translation: the average investor may not be very proficient in completing a scientific assessment of his or her own risk level or taking an unemotional approach to volatility.
We believe that by combining fact-based questions along with a more scientific, goal-based approach to determining an investor’s willingness and ability to tolerate risk, can help provide a smoother ride and a less emotional approach to short term volatility.
Our firm’s client risk tolerance questionnaire fits on a one-page piece of paper with a focus on simplicity and imagery. The form considers the basics of an investors age and long-term investment goals combined with theoretical questions on how much he or she would like to annually earn (realistically) along with how much they can stomach in losses in extreme market conditions. This then helps to select the appropriate strategic model portfolio selection and asset mix.
The first course of action to invest your nest egg for your long-term goals is to determine your risk tolerance and work to ensure that your asset mix of stocks to bonds matches up with your volatility and investment return goals over time.
Set reasonable portfolio return expectations. If cash is paying near zero and the US Markets as benchmarked by the S&P 500 index average about 10%/year for the past four decades, you may reasonably expect to return somewhere between 3% and 10% per year over time in a balanced portfolio – whether you are conservative, moderate conservative, moderate, moderate aggressive or aggressive in risk. Keep in mind that your target return is reduced by fees, taxes and inflation.
Investors can expect to lose purchasing power of 3.1% every year just due to inflation which can increase your cost-of-living adjustments by about 50% up every decade or so. As far as income taxes, consider that no matter what you earn, every dollar taken out of your retirement accounts will be taxed at your current blended income tax rate for the year.
Utilize the appropriate “blended” benchmark to track your progress over time. To re-paraphrase the Cheshire Cat from Lewis Carroll’s Alice in Wonderland, if you don’t know where you are going, selecting any road (or benchmark) will not get you there. If you are in a balanced 60/40 stock to bond (balanced) portfolio, your target benchmark would not be the DJIA Dow Jones Index (news index) benchmark, but a blended benchmark of different asset classes.
The bottom line? The time to complete a risk questionnaire and review your overall investment strategy should be a proactive, ongoing process throughout the year, like a diet or fitness regime, and not something performed as a knee-jerk reaction after a market crash.
Investing “long-term” for your retirement should not look or feel like you are gambling in Vegas or provide angst like you are stuck in a scary Stanley Kubrick film. Disciplined investing for the long run is both an art and science between the science of structured portfolio design and the art of navigating the landscape of behavioral finance while working to determine the rational or irrational exuberance or madness of the crowd.
For more information on our firm or to get in touch with Jon Ulin, CFP®, please call us at (561) 210-7887 or email [email protected].
You cannot invest directly in an index.
Past performance is no guarantee of future returns. Diversification does not ensure a profit or guarantee against loss.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. This report may not be reproduced, distributed, or published by any person for any purpose without Ulin & Co. Wealth Management’s or IFP’s express prior written consent.