How to Think about Risk

As the bull market marches on, everyone is itching to call the top.

  • Some see an economic collapse as the Fed changes course;
  • Average investors worry about markets “up here” with strong memories of prior declines;
  • Pundits proclaim that it is time to “take something off the table”;
  • Those who have been wrong get highlights, insisting on kicking the target down the road, i.e. half cycle? Ten year returns?
  • The market risk/reward calculation is skewed.

This is a complex but important topic. I have written about each aspect in the past, but it is timely and important to pull these threads together. I plan a series of posts (suggestions welcome):

  1. Why risk is an individual question, and why the analysis must include both upside and downside.
  2. Downside risks.
  3. Upside risks.
  4. Hedging strategies: Cheap protection?
  5. Pulling it all together: A plan for action.

This post covers the first topic, but there is more to come.

Risk is an Individual Matter

No one should tell you how much investment risk to assume. Not Warren Buffett. Not CNBC. Not Jim Cramer. And certainly not my blog posts.

Each person has a different investment goal and a different risk tolerance. Everyone would like to have a guaranteed return with almost no risk. Beware of those claims, the basis for the BM approach (think of a famous failed manager and manage a chuckle).

Any investment program starts with an analysis of your goals. Do you have what you need, and are therefore preserving wealth? Or like most of us, do you need to add to wealth to meet your goals? If you are in the latter group, how much risk is required to aim for the needed return?

There are no shortcuts or easy answers. Most of the “coupon solutions” have become a crowded trade. If you have reached for yield – apparently safe – you have assumed risk whether you know it or not. If you have too much invested in stocks, you will be frightened at the first downturn, even if it is a normal fluctuation.

It is fine for Mr. Buffett to say that he would not own bonds and prefer stocks. Most investors need some kind of balance. It is an individual matter. Beware of anyone giving universal advice of the “all in,” “all out” or 50% invested (!!) style. How could these same answers be right for everyone?

Here is a quotation from a piece that I share with investors, but have not published:

Investors have a dilemma — If stocks resume the long-term trend of 8 -10% annual growth, they want to participate. In fact, many of them must participate if they are to meet retirement goals. It is important to realize that this long-term outcome is the most likely.

If the Dow goes to 20K, we would all like to be on board, but what about the risk of another meltdown?

The challenge is how to provide the needed investor confidence in a world where most of the news and commentary is very negative. Many intelligent investors want to participate as they watch the rebound in corporate profits and stock prices. They are willing to assume reasonable, normal risks, but wonder about another economic collapse.

The Dow 20K reference started with the Dow at 10K and many predicting a 50% decline. Here is the history.

To emphasize, I have not been suggesting an “all in” approach. Asset allocation is an individual matter.

Risk Analysis is Balanced

If you think about risk in terms of a stock sell-off, you are an amateur – a deer in the headlights.

Everyone is living longer. Inflation at the rate of 3% cuts your nest egg in half in 24 years. Sitting completely in cash is a decision, and it could be a costly one.

If you want to make a balanced decision about your investments, you need to consider the following:

  • Downside risk
  • Upside risk
  • And most importantly, your own needs.

Taking this approach is stronger than any magical solutions and certainly better than getting scared witless (euphemism TM OldProf).

Conclusion

I have a varied client base – assets, income, age, and objectives. The key message of this post is that there is no universal answer. You should strongly resist anyone who suggests otherwise.

If you right-size your risk, you will be able to hold strong through the normal market fluctuations.

As always, I welcome suggestions on this new series!

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3 comments

  • Johannes June 3, 2015  

    The new series as you have described it sounds great. I would like to see some comment on “market sentiment” – or the “irrational factors” that move the market – mostly in the short term. I have questions like: should market sentiment be considered in deciding when to invest? How long does market sentiment typically influence market returns (X days) and therefore if your investment duration will be 10X (for example) days then it can be ignored.

  • Sam Veneer June 3, 2015  

    Having watched folks from Social Security comment on “living longer” on C-SPAN, I’m not sure that we are living a lot longer. The comments were that if one puts back into the statistical cohort the death from WW-1, WW-2, the flue pandemic of 1917/20 and Polio, then USA males have gained only 1 year in the last 100 years.

  • Tim June 7, 2015  

    Let’s “assume” everyone has “enough” (if you don’t what else can you do) and let’s “assume” everyone wants more”. That seems to be a “law of human nature”. Additionally, a person’s perception of their risk tolerance is greatly dependent on their perception of the market direction that you mentioned regarding asset classes. Thus, the biggest problem is knowing your own risk tolerance. Why would one 40 year old male be different from another? Statistically, I do not understand, excluding extenuating circumstances for short term needs.

    I would appreciate asset class allocation per centage recommendations for the portfolio by age group.
    The big value added would be two fold:
    1) Given the overall economic environment, over/under adjustments from the targets.
    2) Within each asset class, alternate suggestions that reduce risk substantially due to the current environment.
    Sample of this is your points regarding bonds.

    The goal would be a portfolio that can adjust the asset classes and specific investments within each class periodically. The concept is a synergy of the “Robo Advisor” approach and taking advantage of your statistical approach for allocations between classes and the specific investments within a class.

    Bond Ladder, Enhanced Yield, Great Stocks, Felix Trading, Aggressive Stock and let’s not forget Oscar all address a specific component, instead of a balanced portfolio.

    Hopefully, 5.Pulling it all together: A plan for action, would include something along these lines. The goal would be a portfolio tool that can adjust asset class allocations and the investments within the allocations
    utilizing all of the work that you put in regarding the various economic factors and risks. Increase the gas when needed and step on the brakes a little when needed.

    Food for thought.