1st Quarter 2016

What is Risk

There are a few different ways in which risk is measured and discussed, but we will start with this definition: The risk of putting your money into stock investments is that it may not be there for something important when you need it.

The higher the percentage of stocks (risk assets) that you own, the higher the potential for outsized returns. But risk is a double-edged sword.

Taking excessive risk means that you might not only fail to achieve those outsized returns, but that you may actually have less than what you started with. And consequently your money might not be there when you need it.

Investing offers no guarantees. If it did, there would be no risk. Recognizing this fact, savvy investors strive for the proper balance between risk and (potential) reward.

Emotional Temperament and Risk

Novice investors often overestimate their tolerance for risk. This fact can be easily proven by witnessing the number of investors who suddenly abandon their carefully-planned asset allocation and bail out of stocks at the bottom of a bear market.

As an investor, you must ask yourself how much of a loss is really going to keep you awake at night. How much of a loss is going to make you potentially abandon your plan?

History has shown that inexperienced investors move into protective mode when faced with severe market stress. They then respond using their heart rather than their head. Shaken psychologically and emotionally, they quickly override the asset allocation decision which was made in far more cheerful times.

One’s perception of risk is not constant—it fluctuates over time. Risk may be perceived to be practically non-existent in good times and extremely high in times of market distress or during periods of personal emotional trauma. If the novice investor has not been through a full market cycle, including a bear market, it will be very difficult for that person to properly assess their reaction in times of true market adversity

Blending Risk with an Asset Allocation

Settling on an asset allocation seems so elementary that it's often done without much time and energy being expended. Some people just pick a number based on something they’ve seen or read. With the majority of novice investors, that’s how they arrive at the asset allocation.

The dilemma is that often an investor will make their choice of an asset allocation under stable market conditions—when things are rosy and the horizon appears bright. They therefore often tend to focus only on potential price gains—how much money they will make. They don’t envision any serious risks. This point is critical to understand. If the risk can be readily seen, then it really isn’t a risk since the investor can take specific measures to avoid the risk. Instead, risk is about things that no one can foresee.

So, what is an intelligent investor to do?

First, realize that one’s actual or true risk tolerance level is likely to be quite a bit lower during a market crash than it is when the skies are sunny and bright. Yet it is when market conditions are the most severe that being able to recognize and define one’s risk tolerance is most important!

It is also important to focus on one’s goals and one’s specific, individualized investment plan and overall strategy. It is therefore imperative to establish an asset allocation that matches up with those goals. If an investor succeeds at that, they may find it much easier to stick with the original plan.

Risk Tolerance Questionnaires

More on risk. Investors who meet with an advisor are often given a risk analysis questionnaire. Or they might be referred to a website with a questionnaire designed to help choose an allocation. These are only modestly helpful, because investors often fail to gain a full appreciation for the profound impact that exposure to market risk can deliver.

An article in The Journal for Financial Planning entitled "Assessing Risk Tolerance for Asset Allocation, by William Droms, CFA and Steven Strauss, CPA/PFS, challenged the usefulness of questionnaires with this statement: "Virtually all experienced financial planners and investment managers would agree that a questionnaire by itself cannot possibly lead directly to a definitive asset allocation plan."

The biggest problems with questionnaires are that they either ask you how much risk tolerance you have—for which you have no reference point to make a determination—or they attempt to quantify your needs and offer a portfolio without taking into consideration actual emotional risk tolerance.

Maintaining a Perspective on Discovering Risk Tolerance Levels

The level of risk an investor chooses to take should be based on specific needs. The determination of one’s needs should come from examining factors such as age, job type, job security, marital status, contingency plans, back-up resources, and others. These factors must be balanced against one’s emotional tolerance for risk. If needs don’t match up with tolerance, investors are likely to abandon their strategy at the worst possible time.

But one should not take questionnaire recommendations at face value. It is possible to score high on a risk tolerance questionnaire and be ill-suited for high risk because of unrelated or undisclosed personal circumstances. A questionnaire should be just one supplemental part of an overall risk assessment.

The converse is also true—an investor may score low on a risk tolerance questionnaire and be perfectly well suited to a higher risk portfolio. In other words, it cannot be relied on for a 100% assurance or guarantee—it is only a starting point.

Making Up a Loss

Another way to help decide on an asset allocation and risk level is to look at how much an investor has to earn to make up for a loss. Below is a table that shows the gain required to fully recoup a loss.

(insert table here)

Note that the recovery rate is not linear. The higher the loss, the higher the required gain to get even. This is almost never understood prior to experiencing losses.

Balancing Risk and Reward

As you can see from the chart on the previous page, a 50% loss from an all-stock portfolio requires a 100% gain (it needs to double), but a 20% stock loss (which would equate to a portfolio of 50% stocks and 50% bonds where the bonds broke even), requires only a 25% gain—a much more achievable recovery percentage.

A balanced investment strategy, as previously stated, suggests an allocation in the range of 50% stocks and 50% bonds. Such a portfolio may be arguably most suitable for the conservative long-term investor looking for reasonable growth prospects.

Any investor concerned about volatility and excessive risk may benefit from the more conservative balanced strategy. It bears remembering that trying to achieve a higher return on an investment means one must assume a greater degree of risk.

To review, the degree of risk associated with an investment strategy is usually directly related to the percentage of the investment account held in stocks. If less risk is a priority over higher returns, then a more balanced approach may be desirable. Despite the best planning, however, an investor who can conceivably control the amount of risk they want to take cannot necessarily control their future returns.

Over the past 80 years the return on the S&P 500 stock index was significantly greater than that of U.S. Treasury bonds. But to achieve this higher rate of return an investor may have had to suffer through periods of time in which the portfolio lost between 50% and 60% of its value. It obviously requires a disciplined investor with a strong stomach to remain invested in the face of such a staggering drop in account value.

With a properly designed balanced strategy, which takes advantage of both risk assets (equities/stocks) and fixed income (including bonds and cash), an investor strives to achieve a positive rate of return commensurate with the level of risk taken. Although a balanced strategy is not always exciting, it often allows an investor to feel more secure.

In summary, a balanced portfolio offers the best opportunity for investment gains to be achieved in a slow and steady manner—think tortoise and the hare.

Thank you for your continued interest.

Sincerely,

Andrew J.Fama, JD, AEP, RFC®, MHA, Registered Fiduciary (RF™)

Principal, Fama Fiduciary Wealth LLC

Registered Investment Advisor

*Past performance is no guarantee of future results*

*Nothing contained in this quarterly newsletter should be construed as investment advice*

 

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Disclaimer

This newsletter was produced by Fama Fiduciary Wealth LLC, an SEC-registered investment advisory services firm. The content is intended for educational and information purposes only and not as investment advice or an offer or recommendation to buy or sell an investment product. Any investment or tax decision made carries risk including the risk of financial loss and is ultimately the responsibility of the individual who should consult beforehand with a financial or tax advisor. Past performance is not indicative of future returns.

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