Many people invest backward. They focus a great deal on the merits of one stock versus another, or analyze whether the time is right to add high yield bonds or emerging market stocks to their portfolios. But few investors step back and consider how all of their investments add up. As the 2008 market crash and subsequent 2009 recovery demonstrated, the most important decision an investor makes is how much overall risk to take. Your portfolio’s overall risk level should be a deliberate and disciplined choice, and not simply the result of a series of one-off investment decisions.
The simplest gauge of risk in an investment portfolio is the ratio between the percentage invested in stocks and the percentage invested in bonds. Family office investors ensure that their portfolio’s risk level makes sense from a “top down” perspective by carefully monitoring their overall risk level in terms of a simple stock/bond ratio. This is also a simple and effective way to judge a portfolio’s performance over time.
Striking the right balance between risk and safety ensures that an investor will never be forced to turn a temporary loss into a permanent one. Although stocks have higher long-term expected returns, stock prices are much more volatile than bonds and will go down when an investor may need money the most (such as during a recession).
Family office investors set the risk level of their portfolios based on their circumstances, and not on their short-term market outlook. This personal inventory boils down to two major factors – “ability” to take risk and “willingness” to take risk.
Ability to take risk.
This is based on an investor’s current financial situation and future needs and objectives, and is the more “numeric” and quantifiable dimension of risk-taking. Time is the greatest asset for an aggressive investor. While generally one of the main determinants of risk level is a person’s age and how long they have until retirement, many family office investors have the ability to take more risk than their age would indicate because their time horizon extends to future generations.
In addition to evaluating their time horizon, budget, and spending needs, all investors should consider:
Willingness to take risk.
This is more subjective and difficult to assess numerically. While many family office investors have the ability to take a lot of risk due to the size of their assets, every investor must still fully understand their ability to withstand volatility. Otherwise, an investor may make behavioral mistakes such as selling after a large market drop, which often turns a temporary loss into a permanent one.
We recommend thinking about the willingness to take risk in terms of concrete numbers, such as the ability to ride out a major loss, i.e. a 10% loss over a 12-month period. For different combinations of stocks and bonds – ranging from the very conservative 20% stocks and 80% bonds to an aggressive 100% stocks – there is a substantial difference in the probability that a portfolio will decline at least 10%.
Probability of at Least a 10% Loss in 12 Month Period
Note: Ratio represents stocks/bonds target. Assumes no capital gains, fees, or withdrawals. Actual US-only portfolio data from January 1988 through June 2016.
Note the percentage increase in this chance of loss between each incremental level of risk. For example, if an investor moves from a 40% stock and 60% bond portfolio with a 2.4% chance of a 10% or greater loss to a 60% stock/40% bond portfolio with a 5.2% chance, that investor has increased the chance of a major loss by over 100%.
The question of risk is not as abstract as it used to be. The 2008 financial crisis is still quite fresh in the memory of many family office investors, and it served as a concrete lesson in how important it was to be thoughtful about risk. Being invested in a very conservative portfolio meant that the maximum drawdown an investor experienced over this period was around 8%, while an all stock portfolio declined over 50%.
Maximum Drawdown During 2007-2009 Financial Crisis
Note: Ratio represents stocks/bonds target. Assumes no capital gains, fees, or withdrawals.
All investors should behave like sophisticated family offices and step back from their individual trade decisions on occasion to gauge the overall risk level of their portfolios. It is important that this risk level change only because of changes in the investor’s ability or willingness to take risk, and not because of short-term market timing. Just as an investor should be wary of taking too much risk, it is also important not to take too little. There is such a thing as too little risk because inflation will erode your purchasing power over time if you do not earn a sufficient return.
This article was written by Todd Millay from Forbes and was legally licensed through the NewsCred publisher network.
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