In a recent conversation with a client, the word “risk” came up numerous times. The conversation began by discussing their goals and objectives, but as we continued our discussion, there seemed to be many inconsistencies in their thinking about risk and the current structure of their investment portfolio.
The clients were mid-60's, had sold their company and were readily transitioning into retirement. They considered themselves "conservative" investors and would feel uncomfortable if their portfolio lost 10% or more, in any given period of time. Meanwhile, their portfolio was structured in a way that would have experienced a 30% loss in 2008.
Frankly, this isn't a unique situation. Most people aren't always rational or consistent. We are human beings with powerful brains and lots of emotions. Our objective is to help you understand how decisions (rational or not) will affect your future financial circumstances.
Risk tolerance is a term often discussed, but not always understood. At the Raskin Planning Group, we think "risk" is more nuanced that just putting a label on a feeling. What do the terms "aggressive," "moderate" or "conservative" really mean? How do these terms translate into the implementation of investment strategies? What are the client's expectations around volatility and returns?
We look at risk in four ways:
- Risk Required: the risk associated with the return required to achieve your goals, a financial projection.
- Risk Perceived: the risk perceived in the course of action being considered, how risky the action feels to you.
- Risk Capacity: the risk you can afford to take, a financial characteristic.
- Risk Tolerance: the risk normally chosen, a personality characteristic.
Additionally, there are a few more ways to look at risk, specifically in the market.
Security Risk: this is the risk of owning a specific stock or bond. Great companies (large and small) can experience tremendous fluctuations in values because of unexpected catastrophes (e.g. British Petroleum's Deepwater Horizon Oil Spill in 2010) or severe financial pressures (e.g.the bankruptcy of Lehman Brothers in 2008.)
Market Risk: the risk of owning any one security is reduced if you "diversify" your holdings by investing in a large basket of securities that include stocks and bonds from different industries and parts of the world. Owning a diversified basket of securities doesn't avoid volatility. Over short periods of time, markets move violently (e.e. October 2007 through March 2009.)
Event or Political Risk: It's very difficult to predict events like natural disasters, wars or political shocks. Markets will typically overreact in the short-run and slowly recover to pre-crisis norms.
With the knowledge and examples of these pitfalls, it is important to have realistic expectations when it comes to risk and returns. A look back at a variety of market cycles over the last 20 and 30 years can give you historical perspective and may help develop realistic expectations. For example, while a 6% average seems reasonable over 30 years, there have been 5 one-year periods when a similar portfolio dropped in value by 10% or more. With that knowledge, you are able to determine if you are still comfortable with the current investment strategy.
Risk tolerance is just one aspect of a comprehensive financial plan. Your personal goals, income needs, tax situation and risk tolerance will all help determine an appropriate investment structure. An historical perspective will give you realistic expectations so you aren't reacting emotionally when volatility occurs. Stick to your plan and try to enjoy the journey.