The market got off to a rocky start in 2014, with the S&P 500 declining by 4%.1 Between January 15 and February 3 alone, the S&P 500 fell 5.8%,2 and weakness was even greater in areas abroad like Japan3 and the Emerging Markets.4 Many investors were left wondering if the rough start was a sign of things to come.
How did it make you feel?
We think the recent volatility presents investors with an opportunity as well as a friendly reminder: it’s a good idea to regularly make sure your portfolio is allocated according to how comfortable you are with stock market declines and risk.
With Investing, Feelings Make a Difference
A recent study by Morningstar concluded that in the ten-year period ending in 2013, a typical investor booked a 4.8% annualized gain, while the typical fund gained an average of 7.3% a year.5
Why is this happening? We think a main reason is that many investors don’t assess how comfortable they are with risk often enough, and in some cases they’re not assessing those comfort levels correctly. This can lead to poorly timed shifts in their portfolios, which can hurt their ability to reach their retirement goals.
Being confident that your portfolio is invested accordingly with the level of risk you are willing to accept will help prepare you for difficult times in the market.
Are You Taking Too Much Risk Now?
If January’s market decline caused you concern, it’s possible you’re taking on too much risk in your portfolio and are over-allocated to stocks. You probably want to sit down with your financial advisor and reconsider your asset allocation.
If the pullback didn’t bother you much, it’s an indication that your portfolio is better aligned with your comfort for risk, and you may not need to make any adjustments at all.
How Should Investors Assess Risk?
We think risk assessment happens in two steps: first is to determine how much risk you are comfortable taking. (“risk tolerance”), and second is to determine how much risk you need to take in order to achieve your financial goals, also known as your recommended level of risk.
In our view, these two steps are actually very different things, and as such investors need to think about them differently when considering the right asset allocation for their portfolios.
Assessing Your Comfort with Risk
When you think of the word “risk,” which of the following words comes to mind first?
1. Danger
2. Uncertainty
3. Opportunity
4. Thrill
Your response to this question can help you understand how much risk you’re comfortable taking in your portfolio, otherwise known as your “risk tolerance.” It’s a purely psychological measure.
For instance, investors who said “danger” should probably have lower equity exposures in their portfolio, while on the other end those who answered “thrill” are probably more willing to cope with losses in hopes of achieving greater rewards over time – making higher equity allocations more suitable.
How Did You Feel the Last Time the Market Declined?
Another way to measure your comfort with risk is by asking yourself how you would feel if your portfolio experienced a 15-20% decline. Could you stomach it? Were you taking on too much risk in the 1990s during the tech bubble? How about more recently during the 2008-2009 market declines?
Your comfort with risk is important to understand, but it shouldn’t be the sole determinant of your investment approach. There’s more to the risk story.
Recommended Level of Risk: How Much Risk Do You Need to Take?
Your recommended level of risk will depend largely on how much money you have saved as well as what your goals and needs are throughout retirement. In other words, this is more reliant on your financial situation than it is your psychological comfort with risk.
Take for example a “conservative” investor who is 70 years old and has $1,000,000 saved, but needs to withdraw $5,000 per month to cover living expenses.
Based solely on their comfort with risk (“conservative”), this investor might favor a more balanced portfolio, say a 30% stock / 70% fixed income allocation,.
However, a 30% stock / 70% fixed income allocation might not produce the growth needed over time to keep up with withdrawals. In this case, the recommended level of risk is different from the investor’s comfort with risk, and the investor might need to make adjustments to their portfolio in order to reach their goals.
Finding the Right Balance of Risk in Your Portfolio
Having the help of a financial advisor in these cases is key – it’s important to have a thoughtful conversation about how to reconcile your comfort with risk versus your recommended level of risk, especially if the two are quite different.
WrapManager Can Help Show How Much Risk You Should Take in Your Portfolio
If you’re interested in taking a closer look at how your portfolio is allocated relative to your comfort and recommended levels of risk, you can have one of our Wealth Managers build an investment plan with you.
Give us a call today at 1-800-541-7774, or get started by answering a few questions here. The first step toward making sure your portfolio is allocated appropriately is by creating a greater sense of awareness for what your risk levels actually are. We can help you get started.
Sources:
1 Fidelity
3 CNBC
