In my last blog post we discussed market performance and that to outperform the market you need to be able to underperform the market for some period of time. But we also said that most successful investors recognize that the best portfolio isn’t the one that has the potential to make the most money, but the one that they can stick with for the long term.
Of course, all investors are not astutely aware of their own risk tolerance, or the amount of risk being taken in the portfolio. In fact, often they will misjudge the amount of risk in their portfolio, and not realize the problem until it is too late. And it’s at the moment that the investor realizes that they were taking more risk than they were comfortable with, that they decide to bail out. Said another way, the key issue isn’t gaps between their portfolio and their risk tolerance, per se, but the gap between the perceived risk of their portfolio and risk tolerance. Again, it’s not merely “investing too aggressively” that’s the problem, the problem is that at the moment they realize that they are invested too aggressively, it triggers a behavioral (and often problematic) response. They bail!
So let’s imagine, dear Investor, that your portfolio is experiencing some volatility and the volatility leads you to believe you have made a bad investment decision. Even with an appropriate portfolio, you may misperceive the risk you are taking!
As an example, let’s imagine an investor who is extremely tolerant of risk. They are a successful serial entrepreneur, who has repeatedly taken calculated high risks, and profited from them. Their portfolio is (appropriate to their tolerance) invested 90% in equities.
But suddenly, a major market event occurs, like a war or a financial meltdown, akin to the 2008 financial crisis, and they become convinced that the whole financial system is going to collapse.
As a highly risk-tolerant investor, what would the appropriate action be if you were very tolerant of risk, but convinced the market was going to zero in a financial collapse? You’d sell all your stocks. Even as a highly risk tolerant investor.
But the key point again is that our investor’s risk tolerance isn’t changing in a bull or bear market. They remain highly tolerant of risk. The problem is that their perceptions are changing… and that it’s their misperception that a bear market decline means stocks are going to zero (not just declining before a recovery) that actually causes the “problem behavior”. Because it leads the investor to want to sell out of a portfolio that was appropriately aligned to their risk tolerance in the first place!
Many of us have these behavioral biases and managing them is key to investment success. The key point here is that whether we are conservative or aggressive we can have challenges staying the course in bull and bear markets, even if our risk tolerance remains stable. It comes down to our risk composure through market cycles. If our risk composure is low, we are more likely to misperceive risks – to the upside or the downside – and that could trigger potentially ill-timed buying and selling activity.
The bottom line, though, is simply to recognize and understand that in times of market volatility, what’s fluctuating is not risk tolerance itself but risk perception. The more you can figure out how your risk perceptions are misaligned with reality, or that you have low risk composure and are prone to such misperceptions the better you can identify that you might need help (via a financial advisor, or other interventions) to stay the course!
Nobody minds market volatility when it’s in the upward direction. But recently we’ve gotten plenty of the type of volatility that we don’t like so much as investors, the kind that inspires headlines with words like “plunge” and that end with exclamation points.
It presents an opportunity, therefore, to remind ourselves of one of the central tenets of the art and science of investing: You can’t get outperformance without underperformance.
Indeed, the only reason we have a right to expect a higher rate of return on any given investment is that we’re willing to endure greater risk, and, likely, higher volatility. But just how much volatility?
Let’s look at some of the scariest market moments of the past 50 years, specifically how far the market—in this case, the S&P 500—dropped over a handful of notable time periods:
But let’s be sure to put the word “only” in quotes—because if you saw your retirement nest egg of
$1 million come crashing down to $447,000, my guess is that you were more than a little stressed out. In fact, I think it’s fair to suggest that most investors with “real money” on the line simply couldn’t handle that type of drawdown. Most would bail out. Maybe you did.
That’s why the most successful investors recognize that the best portfolio isn’t the one that has the potential to make the most money, but the one they can stick with for the long term. The goal isn’t squeaking out another percentage point or two of return over your lifetime while white-knuckling your smartphone, sweating over your investing app of choice, every time the reality of investing returns to claim its risk toll.
Instead, consider acknowledging this reality—and your own personal willingness to endure risk. Then offset the growth engine of your portfolio—your exposure to stock—with the stabilizing agent of the most conservative, boring fixed income or bonds. Consider the following gut check test, the goal being to match your maximum tolerable loss with an appropriate maximum equity exposure: At what point will you not be able to sleep or wish to go completely to cash? 10% loss, 20% loss, 30% loss?
To use this simple guide most effectively, don’t try to imagine what a particular percentage loss would feel like; multiply the value of your investment portfolio today by the number on the left and use actual dollars. Even then, hypotheticals can be challenging, rarely drawing out the actual feelings we’re likely to endure in real life.
So if you were invested in any of the crises listed above, ask yourself the question, “How did it feel to lose ___% of my portfolio back then?”
And when in doubt, err on the side of conservatism, because we tend to feel the pain of loss twice as strongly as the joy of gain—and because it feels better to miss out on a little upside than to bail out on an overly aggressive portfolio after losing a lot.
The question most investors have is “Then how should I invest?” Should I own stocks? Bonds? And if both how much of each?
Stay tuned and we will discuss how to structure a portfolio, next week.
Sally J Boyle
Sally Boyle is committed to being high-net worthy. A certified financial planner, she believes the single most important part of any wealth planning process is her conversation with you.