13 Jun 2014 Did You Know There Are Two Kinds Of Investment Risk?
Risk in investing is generally understood to mean the possibility of losing money. But there is a more important distinction to consider. For instance, when you work with a broker or a money manager you complete a risk tolerance questionnaire. It basically asks you what is the maximum point of risk (loss of your money) you can stand before you spend sleepless nights and stomach-sick days?
Then there’s the second question regarding risk, that unfortunately is asked far too infrequently and is not as easily answered. It is, what is the level of risk required to accomplish the things that are most important to you? To answer this question, you and your financial advisor must build a plan that accurately describes your life’s priorities and goals. It should be regularly tested using Monte Carlo probability analysis to ensure that your plan remains on track.
The cost of taking more risk than necessary
Virtually every client we serve has stories of losses they incurred during past market crashes that tested the upper bands of their risk tolerance. Some endured the pain to stick with their programs while others abandoned them indefinitely or permanently to pursue ‘safer’ investment options like CDs and annuities. Much of our time with new clients is spent undoing the financial and emotional damage wraught by portfolios that were designed to give them ALL of the risk they could tolerate. Sadly, had they received advice that positioned them to take no more risk than was required to meet their goals, they would be thousands or millions better off today! In short, their financial ‘advisors’ measured the wrong risk.
In late 2009 we acquired a client who had a terrible experience in the 2008 market rout that preceded the Great Recession. Her broker had positioned her in a portfolio that delivered the amount of risk she thought she could tolerate, rather than developing a plan to determine if she needed that much risk. In 2008 when the S&P 500 index sank 38%, she lost 35%. Worse than that, she abandoned the markets just as they were preparing to rally. As a result, she missed a large chunk of the rebound that started in March of 2009.
During the time I spent developing her plan I became curious as to what portfolio we would have recommended to her back in October 2007 with her higher asset values. To my surprise and anger, it was clear that she had been sold entirely too much risk. Our Balanced Income portfolio with 45% stocks would have been the clear choice to confidently meet or exceed all of her goals. Sadly, had she been in that portfolio then, she would have had $882,000 in December of 2008 instead of $650,000.
To make matters worse, after many sleepless nights when she could bear it no more, she cashed out just before the rally that would come in March of 2009. Had she been with us in 2007, in our Balanced Income portfolio, she most likely would not have cashed out. By sticking with her portfolio through the 2008-09 dip, she would now enjoy a portfolio worth $1,410,000 rather than the $1,040,000 she has now.
The cost of not taking enough risk
The other side of the coin – taking too little risk, is usually caused by taking too much risk in the past and getting burned by it. When markets tumble, many are frightened away, sometimes permanently from the long-term wealth-building benefits of the capital markets (stocks and bonds) and into products like annuities and CDs. These investments carry more subtle forms of risk that can be just as dangerous to your future lifestyle and that of your heirs.
Annuities are sold with all kinds of sizzle phrases like guaranteed lifetime income and market upside potential without the downside risk. But it depends upon how you define downside risk. For instance while that guaranteed steady income rolls in, inflation is also guaranteed to steadily erode your spending power. A dollar today will buy only 74 cents worth of something ten years from now with 3% inflation.
Fewer people might buy annuities (particularly index and variable) if they realized the cost and the low odds there will be anything left for their heirs. The guy selling it makes more money on it than the customer in the first few years. The insurance cost, the administrative cost, and the funds’ cost can rise as high as 2 or 3%. Say the company promises a return of 6% over roughly 30 years’ life expectancy, one realizes the odds are slim indeed that the company will be able to generate the 9% (6% to you plus 3% in fees) required to pass any remaining funds on to heirs. Annuity owners are in essence paying the insurance company to give them their own money back over time. Most of any upside goes to the insurance company.
Risk comes in many shapes and forms, but if you take the time to understand just how much you need to accomplish your goals, then the capital markets can be made to work for you rather than against you.