“Everyone has the brainpower to make money in stocks. Not everyone has the stomach.”
You have probably given some thought to how much risk you are comfortable with when it comes to your investments, but unless you deal with market fluctuations on a daily basis for an extended period of time, it is hard to gauge what appropriate risk looks like. It is a known fact among financial professionals that people routinely overestimate, or underestimate their tolerance for risk. The result is that most investors have significantly worse performance in their portfolios than the market averages do as a whole. This is easy to understand because you only have your own experience to relate to. So if you have had a good run, or a bad one, it looks, from your point of view, like that is the nature of the markets and that can either overinflate your confidence, or inappropriately deflate it.. It is a little like an example in the book “Moneyball”. In that book the author, Michael Lewis, gives an example of how because of the nature of a limited random sample, a baseball scout, by watching a particular prospect in several games can easily get the wrong impression as to his abilities. This shortcoming in the scouting world has led to sabermetrics, or the statistical analysis of players. That same thing can happen when we look at our experience while investing, and the same solution can be applied, i.e., a statistical analysis of markets. The reason people misgauge their risk tolerance isn’t as important though, as it is to recognize that if this describes you, you are not alone.
A look at some relatively recent history can be instructive. Had you invested $10,000 in the Standard & Poor’s 500, in October 1995, your investment would have grown to $25,483 by August 2000. Not bad for less than five years. But your $25,483 would have been worth…
$14,887 in September 2002
$26,419 in October 2007, and
$12,989 in March 2009.
As of July 2016, your investment would be worth $36,076. An average annual return of 6.38% over a little less than 21 years, but what a ride! Not only that, but that average annual return would have been 2.18% if you had first invested that $10,000 in August 2000 instead or October 1995! This is, pretty, much what a passive investment in an index fund would have looked like.
Given enough time, stocks have historically given some of the best investment returns available. But the key words are “given enough time” and “historically”.
In the past, the answer to that volatility has been bonds. Because bonds guarantee an interest rate and the return of principle, they were considered much less risky. There were, therefore, two risks to keep track of in the bond world. One was credit risk, i.e., was the issuer of the bond able to fulfill those guarantees. To help with that risk, bond issuers are given credit ratings, just like you and me. The higher the credit rating, the safer the bond and the lower the interest rate they offered. The second risk was interest rate risk. Here is the way interest rate risk works. If you buy a bond today that pays 4% and you want to sell that bond next year, what you can sell your bond for will depend on what interest rates have done in the interim. If interest rates have gone from 4% to 3%, you can get a premium for your bond because it offers a higher interest rate than the market is currently paying. On the other hand, if interest rates go from 4% to 5%, you will have to offer a discount on your bond to entice a buyer to accept a lower interest rate on their investment. And here is why I spoke of bonds as a solution to the volatility problem in the past tense. As of August 30, 2016, the 10 year Treasury note was paying 1.57%. Interest rates are as low as they have been in my lifetime. Because of that, the interest rate risk bonds present largely offsets and exceeds the guarantees they provide.
So what is the answer? The idea behind diversification is to have different investments that tend to behave differently to various market environments. When two investments behave in lockstep with one another, they are said to have a correlation of 1. If they behave opposite to each other, they have a correlation of -1. And when one investment’s behavior is completely unrelated to the behavior of another, they have a correlation of 0. What we look for when we diversify is a low or negative correlation between investments. That can be any number of things, and when investing for my clients, I use several of them. I wouldn’t omit bonds all together, because they do provide some interest rate and they are a different asset class than stocks, but they are clearly insufficient, in today’s environment, to insulate you from the whipsaw that can be the stock market. Other kinds of diversifying investments can be real estate based investments (REITs for example), precious metals, energy, inverse ETFs, and annuities as well as others. Then there is the fact that there are nearly always some stocks &/or sectors that will be winning while others are losing. There may be times when it will be wise to have more money in cash both as a buffer against a volatile market and to be in a position to buy up bargains when they are available. Financial professionals may use both technical and fundamental analysis of market conditions and individual companies in an effort to keep track of all of these moving targets.
When allocating your portfolio among these various asset classes, you will want to look at a number of things. Your age tells you something about how patient you can afford to be. How likely are you to get scared and pull your investments all together when things look bleak? What other resources do you have? How have you behaved to market swings in the past? One reason some people have a financial plan is to help with this evaluation. Producing an individual financial plan enables us to look at your circumstances in particular, rather than some generic rule of thumb. It also provides a basis to have confidence in your investment plan when things get scary.
Just like in baseball and sabermetrics, trying to find uncorrelated assets to make up a portfolio using historic data, gives you information about what has happened in the past. It is not a crystal ball. We need to realize that when we are investing, we are shooting at a moving target. It is important to continually readjust our aim. But it is also important to understand that in order to invest in our future, we do not have to ride the stock market all the way down or stay out of the market all together. There are ways to have some of your cake, and eat the rest.
Investments & advisory services offered through KMS, Financial Services, Inc.
© Richard D. Gale, ChFC, LUTCF