Is It Time To Rethink Your Tolerance For Investment Risk?
By Andrew Willms, President & CEO
The recent turbulence in financial markets is another reminder that while investing in stocks creates the potential for higher returns than government bonds, cash equivalents, and other stable investments, this opportunity comes with greater risk. It was easy to overlook this inconvenient truth when stocks were racking up impressive gains for much of the past decade. But when the Covid-19 pandemic brought the party to an end, many investors discovered that their tolerance for market risk was lower than they assumed when the bull market was roaring.
The fear of missing out can cause even the most seasoned investor to over-estimate their ability to endure bear markets. When the market is rising, most of us tend to overestimate our ability to keep the faith when the market eventually changes direction, as it inevitably will. Not surprisingly, many of those original estimates fall to the wayside when the market cracks. That’s a problem because selling stocks during a bear market, and then buying them back during a bull market is a losing investment strategy.
Several factors come into play when evaluating risk tolerance. Some of the most significant are age, time horizon, personality type, along with other variables that reflect who you are as an investor. At a basic level risk tolerance boils down to 1) the amount of risk you need to accept to achieve your financial objectives, and 2) your ability to stick to your investment plan when markets crash. Risk tolerance questionnaires can help with this assessment, but often times their results depend on your current frame of mind. Moreover, your risk tolerance is subject to change as your circumstances change. That’s why I recommend you have an annual conversation with your financial advisor regarding your current investment objectives and risk tolerance.
Once you have a solid understanding of your capacity for bearing risk, the focus turns to building a customized portfolio that’s consistent with it. As a simple example, consider a basic stock/bond portfolio, based on two mutual funds: Vanguard 500 Index Fund (VFINX) for stocks and Vanguard Short-Term Federal Fund (VSGBX) for bonds. By adjusting the weights for these two funds – a.k.a. changing the asset allocation – we can customize the portfolio to match the investor’s risk tolerance.
For investors who can stay the course when encountering bear markets, the payoff for bearing more risk can be substantial. For instance, the chart below shows how different mixes of stocks and bonds (with year-end rebalancing) fared over the past 30 years. Higher weights in equities earned higher returns through time, but at the cost of severe short-term corrections. Portfolios with higher bond allocations delivered a smoother ride and suffered less in bear markets, but at the price of lower returns.
At The Milwaukee Company, we believe that rules-based investment strategies that are supported by academic research and thoroughly tested is an effective way to manage investment risk while preserving returns. We have developed several strategies that target various levels of risk by tapping into various asset classes on a global basis. We also apply additional risk-management techniques to further refine portfolios to satisfy a client’s investment objective and risk profile.
Next time, we will discuss tactical asset allocation, a core component of these strategies. Until then, take care and be safe.