Clear Direction for Your Retirement: Investment Risk: How Are You Managing It?
Few terms are used in the investment world as much as “risk”. I think if you’ve followed the markets for the last few years this would go without saying given the extreme and in some cases historical market fluctuations. Most advisors and financial media talk about investment risk in terms of price volatility of a given security. However, there are many different types of risk in the financial world. For instance, inflation risk, interest rate risk, reinvestment rate risk, default risk, liquidity risk, well, I think you get the picture.
On a practical level, we can say that risk is the chance that your investment will provide lower returns than expected or even a loss of your entire investment. This also creates con-cern about the chance of not meeting your investment and income goals. It should be understood if you’ve been investing long that investment in the stock and bond markets carries some degree of these risks. There’s no guarantees, just degrees of risk and reward depending on where you decide to put your money. In general, the more risk you’re willing to take on (whatever type and however defined), the higher your potential returns, as well as potential losses.
How Do You Define Risk
It is true that when we speak of risk from an investment perspective it can involve many different underlying types of risk as we’ve just mentioned. However, most folks we meet with think of risk in a simpler way. When you boil it all down, they only care about the value swing of their account balance and the risk of loss! So ask yourself, how do you define risk? I’m willing to bet you’re in the camp I just described and rightfully so. More importantly, ask yourself, what strategy am I employing right now to manage my risk of loss? This is the question that few ask and even fewer truly understand.
Understanding Your Risk Tolerance
The concept of risk tolerance is twofold. First, is that of your desire to assume risk and your comfort level with doing so. That is to say, knowing your own feelings about taking chances. Second, concerns the fact of what you NEED to make a financial plan work for your situation. That is, your financial ability to cope with the possibility of loss depending on your age and overall financial needs and goals. We believe the best approach for iden-tifying both is to approach it mathematically, not emotionally.
Dynamic vs Static Risk Management Once your tolerance is evaluated, you have a choice as to how to manage your investment risk. Depending on your investment firm and advisor and their approach, you can manage risk either dynamically or statically. Most don’t even realize this fact because they’ve only known or heard one way of doing this and that is statically. I’ll attempt to summarize these next without getting off into the weeds too far. It’s important for me to emphasize here that no one approach is 100% success-ful all the time. What you need to determine is which methodology works best for your financial needs and risk tolerance given the implications of each approach.
Static Risk Management
Most folks are familiar with this approach but possibly by different terminology. You may have heard it described as a buy and hold investment strategy. The concept is that you buy a static percentage of stocks, bonds or other investments (like a 60/40 portfolio – sometimes called the “balanced portfolio”) that are diversified across various asset classes (or even sub-classes and sectors) and you hold them long-term, come what may, it doesn’t typically change. In times of heavy market losses, time is always the friend of the static approach. I know you’ve heard it. “Just hold on, the market will always come back”. Will it? History would say yes, but whatever happened to “past performance is not a guarantee of future results?” The bigger question in this methodology is that it speaks very little to the timing of major market cor-rections and your retirement date and need for distributions (sequence of returns risk).
Dynamic Risk Management
Generally speaking, dynamic risk manage-ment (which we employ here at our firm) works from the premise that not every stock or bond, class or sector is appropriate to hold all the time. Additionally, increasing or decreasing risk exposure to the market altogether may need to be adjusted at times. That is to say, there may be times where it’s better to be in cash rather than riding out a precipitous drop in the market. This is anath-ema to a static risk approach. Obviously, we are not talking about market timing, that’s a fool’s errand. However, if one is willing to apply quantitative, fact-based assessments in short, intermediate and long-term time frames, one can spot trends and opportuni-ties. Market conditions can be sought that allow for more or less risk depending on what’s happening NOW versus what one “thinks” may happen over time into the future.
There is a lot of fear and uncertainty in the markets today. John Templeton’s maxim that “bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria” is, I believe, on full display. Seeking to avoid disaster in your investments is no accident, know your risks. Let us know how we can help you find Clear Direction for Your Retirement®.