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):
- Why risk is an individual question, and why the analysis must include both upside and downside.
- Downside risks.
- Upside risks.
- Hedging strategies: Cheap protection?
- 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).
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!