We just discussed how a negative market can destroy our confidence in the investments we’ve made and how we’ll do just about anything to avoid losing. Now, let’s talk about how risk plays a part in our financial planning and how we can best account for it.
This is my definition of risk: the prospect that we will not have the money we need when we need it.
The easiest way to demonstrate this concept is by using the example of someone who is saving up to make a specific purchase, let’s say a car or a house. It should be pretty obvious that if a market-driven investment is used to save for such a purpose and a significant market decline occurred just before the purchase was to be made, then that might compromise an individual’s ability to make that purchase.
How to Account for Risk
This is where allocation beings to take center stage. What is allocation? My definition: the assets, and the amounts thereof, that make up your portfolio.
Why does allocation matter in a discussion about risk? If risk is a question of having money when you need it and if different assets experience more or less volatility, then the assets in which you are invested will go a long way in determining the volatility you will experience, thus determining, in part, whether you will have the money you need, when you need it. In other words, your mix of assets (asset allocation) determines the amount of risk in your portfolio.
Allocating funds to different assets and asset classes impacts the overall risk level in your portfolio in two ways. First, a portfolio comprised mostly of assets with higher levels of volatility stands a good chance of having a higher level of volatility, itself. This can be offset, however, by the second way in which asset allocation can impact the risk level of a portfolio: the degree of correlation between assets.
Correlation is simply the extent to which the prices of two assets move in the same direction. Two assets that are perfectly correlated would move in the same positive or negative direction at the same rate. Two perfectly uncorrelated assets would move in the opposite direction from each other at the same rate. A well-diversified portfolio comprised of assets that are correlated, or not, to varying degrees can help buffer a portfolio’s value with positive performing assets to offset negative performing assets.
What should you do to determine the best allocation for you?
The first place to start is with your comfort with volatility—this is also called risk tolerance. Typically, an investor’s risk tolerance will be assessed with a questionnaire. The purpose of this assessment is to get as firm of a grasp as possible on an investor’s expectations, with the specific objective of determining what would make the investor uncomfortable.
The next piece to address is to define the return that is needed to achieve a goal. There are at least three factors to be considered in defining the return needed: the amount of money needed to fulfill the goal, the amount of time until the money is needed, and the amount of money that the investor can commit to saving. Frankly, it is entirely possible that the return that is determined to be needed might involve risk that is too much for the investor’s tolerance. The complete discussion of that scenario will be reserved for another day but suffice it to say that compromise might have to occur, and that merits thorough and sincere consideration.
The last piece in determining the best allocation for you that I will reference would be some sort of Monte Carlo analysis. I recently created a YouTube video that explains what Monte Carlo is, how it works, and what it produces. For our purposes, we just need to know that it is a way to evaluate prospects for investing success, as defined by a probability that is calculated from running simulations of your plan.
The simulations do what conventional calculations do not, which is take into account investment volatility—conventional time value of money calculations only take into account linear returns. Frankly, Monte Carlo analysis might be overkill for something like a one-time purchase of a car or house, but when dealing with someone’s complete financial plan that involves multiple financial resources, diversified investments, a multitude of risk factors, most likely several goals, and a relatively long period of time, it is an absolutely invaluable tool.
In particular, I appreciate the fact that one of the tools that I use for plan analysis automatically runs simulations for various portfolios with different risk levels. This affords me the chance to see if the amount of risk that is being taken in a portfolio is even necessary. This isn’t true for everyone, but several clients have appreciated me pointing out that the amount of risk they were taking, while within their comfort level, appeared to be unnecessary for the success of their plan.
One last important point that I would mention about Monte Carlo is that it can directly address a concern that some clients have shared with me and that I have observed in others who might have been reticent to share the same. This is the best way that I can define the concern: negative market performance automatically portends the failure of a financial plan. It might be easy enough to read that and understand that negative market performance and plan failure are not synonymous, but I have seen, firsthand, just how significantly emotions can obscure rational thought, particularly when fear is involved. Essentially, Monte Carlo takes into account all manner of market environments, because of the random returns it uses and the number of simulations it runs.
So, if a negative market shouldn’t automatically lead to investment changes, what should?
Don’t get me wrong, I’m not intending to say that there is never a situation where something about your investments should be changed. What I am intending to say, however, is that your investments, and the strategies that have led to their selection, should absolutely be appropriate for any market environment.
In order to ensure that is the case, you must account for the potential downside of the markets. If we only focus on the upside, we might be at risk of getting distracted by reward tolerance, and I have yet to meet someone who couldn’t tolerate as much reward as the markets could throw at them. If the downside has been taken into account, then this should absolutely mean that there is nothing unique about a negative market environment that would justify changes.
Assuming that we have done a good job of following what I have outlined above to arrive at the proper allocation, then there are three things that I would mention that could justify changes to a portfolio:
A change in risk tolerance.
Simply because someone conveyed a certain level of comfort with risk at one point, it doesn’t mean that they will forever be comfortable with the same level of risk. Further, some folks might not really grasp the concept of risk and only through experiencing what it is like to invest do they learn the true nature of risk. It would also be important to note that, generally speaking, the closer someone gets to fulfilling a goal, the less they can tolerate volatility, thus their tolerance for risk would be lower.
A re-evaluation of the return needed.
Similar to what I described above, it might be determined that, at a certain point, an investor might be ahead of the pace they need to achieve their goal. This might open the door to reducing risk, and the reason an investor might do this would be to reduce unnecessary risk. Risk that is unnecessary would simply be risk that is in excess for what is needed. This excess risk might lead to losses that would compromise progress, and ultimately success.
Poor manager performance.
Fundamentally, evaluating manager performance is a matter of benchmarking. I know you would have never guessed this, but benchmarking starts with choosing a benchmark. The benchmark that is chosen should be similar in composition, and/or objective, to the investments that you hold. It should be obvious, but portfolios with a similar composition, and/or objective, should perform in a similar fashion. This means that the ideal would be to always beat the benchmark. Regardless, it should be considered unacceptable to consistently lag expectations predicated upon a benchmark.
As investors, we should be rational and shrewd. Emotions are going to come into play, and they are not always bad for us to experience, but that for which they should be used and that for which they are used aren’t typically the same thing. Emotions can, and should, inform our need to evaluate, and hopefully affirm, our approach to investing.
Conversely, emotions should absolutely not inform our decisions regarding our investments. After all, if it is the market that can cause us to get emotional, good and bad, and if markets are unpredictable, then that may very well mean that our emotions are unpredictable. If our emotions are unpredictable, then what does that say about the decisions we base upon them and the outcomes thereof?
Asset allocation and diversification strategies cannot assure a profit or protect against a loss.
Tools such as the Monte Carlo simulation will yield different results depending on the variables inputted, and the assumptions underlying the calculation. The assumptions with respect to the simulation include the assumed rates of return and standard deviations of the portfolio model associated with each asset. The assumed rates of return are based on the historical rates of returns and standard deviations, for certain periods of time, for the benchmark indexes comprising the asset classes in the model portfolio. Since the market data used to generate these rates of return change over time your results will vary with each use over time.
Monte Carlo Analysis is a mathematical process used to implement complex statistical methods that chart the probability of certain financial outcomes at certain times in the future. This charting is accomplished by generating hundreds of possible economic scenarios that could affect the performance of your investments.