Over the course of their career, retired and affluent investors have worked hard to build a viable nest egg. And in many cases, these wealthier investors are often the most risk averse, which can be attributed to a variety of reasons. They may have dealt with a negative financial experience that caused them to fear risk or perhaps they have already accumulated enough money during their lifetime to achieve their financial planning objectives. Having reached their accumulation goals, they don’t want to lose their hard-earned gains in case the financial markets become volatile.
No investor can know for sure when the markets will correct and for how long. Daily market news and commentators who call themselves “experts” often tout when the next big market crash will occur or spill hot stock ideas. They sell their advice on fear as a way to improve their ratings and viewership. However, these mixed messages often strike the wrong tone — they make investors anxious and cause them to abandon their long-term investment plans and react to short-term movements. Not to mention, the stock market is now inundated with technology and advanced trading systems, giving the perception that they move faster than they have in the past.
With all of these competing external factors at play, affluent investors often misperceive some of the most important rules for managing portfolio risk. They forget to focus on the factors they can control (and the market is not one of those factors). While market volatility can be unnerving, you can implement a few practices to help you manage uncertainty and have confidence in your long-term plan.
Here are three rules of thumb to remember during stressful periods in the market:
1. A Diversified Portfolio Is Your First Line of Defense
You can manage risk by investing in a diversified portfolio spread across multiple asset classes. A globally diversified portfolio broadens your investment universe — this includes stocks and bonds, different asset classes, companies of different sizes and other countries which may move in various different directions at any given time.
You can’t time your investment decisions based on which area of your portfolio will perform the best because you will never know which market segments will outperform from year to year. However, having a globally diversified portfolio can put you in a strong position to seek returns wherever they may occur. There is also a silver lining to benefit from when components of your portfolio go up and down — it gives you the opportunity to rebalance your portfolio and naturally take advantage of the old saying, “buy low and sell high.” However, concentrating your portfolio in a small number of individual-company stocks can actually increase your portfolio risk.
Harry Markowitz famously called diversification “the only free lunch in finance.”1 The idea is that an investor can benefit from diversification in the form of lower risk with a lesser chance of sacrificing returns. Markowitz’s work in this area helped win him a Nobel Prize in Economics and laid the foundation for modern portfolio theory (MPT).
2. Establish Appropriate Cash Reserves
If you’re retired and relying on your portfolio to sustain your lifestyle, you should aim to have enough cash on hand to buffer market downturns. You can avoid selling assets in a down market that is locking in losses by forgoing distributions from your portfolio when markets become disruptive and instead turning to your cash reserves. Some financial advisors recommend that retirees have three to six months’ worth of living expenses on hand in case of an emergency. You may want to take this a step further by keeping even more cash reserves on-hand, beyond the three-to-six-month recommendation.
From start to recovery, market downturns have lasted approximately two years on average.2 Once your diversified portfolio recovers from a downturn, you may choose to start taking regular distributions from your portfolio again. When you have short-term cash needs, you should avoid putting your investment funds at risk.
3. Understand Your Risk Tolerance and Assess It Regularly
Some financial websites advertise multiple-choice questionnaires that claim to help investors measure their risk tolerance. However, the problem with these questionnaires is that they are often outdated or too simplistic in their construction; in many cases, they don’t keep up with advancements in the professional understanding of the markets and investments. In addition, taking these questionnaires in both good and challenging market conditions can alter your perception of risk and complicate your score. That’s why it’s so important to enlist the help of a competent, fiduciary financial advisor, one who will get to know you, develop a long-term financial plan focused on your goals and provide an unbiased risk assessment.
A basic risk tolerance questionnaire only measures an investor’s emotional mindset or willingness to accept risk; conversely, a comprehensive personal financial plan will assess an investor’s risk capacity. In other words, your advisor can help assess your financial ability to absorb losses and develop a plan around it, without impacting your current lifestyle or future goals. An advisor can examine your risk capacity holistically to help ensure you’re in the proper asset allocation to achieve your long-term financial life goals.
The right financial plan is ever-changing and not static — after all, your personal goals and situation will evolve over time, and so should your financial plan. It’s important to review your financial plan with your advisor on a regular basis and revisit your risk tolerance as well as your attitude toward investing and current financial condition.
If you’re married, you and your spouse should evaluate your risk tolerance separately and then review your results together. Understand how your risk tolerances differ and work collaboratively with your advisor to develop and implement a plan that works for both of you and your collective financial goals.
Need help evaluating your risk tolerance or your long-term financial plan? Contact a member of our advisory team today.