As an investor, you probably hear a lot about risk. Phrases like “risk tolerance” and “risk profile” are part of the usual investment discourse, but when it comes right down to it, you may not be aware of how powerful it is to actively pay attention to the risk parameters of your portfolio. Of course, worrying when markets are down is normal, but investors can find it a lot easier to focus on gains or big winners rather than the gloomier subject of potential losses. We just like those positive numbers! However, this innocent tendency to think about the good stuff is actually a mistake when it comes to your portfolio. In fact, I consider it to be an unnecessary gamble with your hard-earned assets.
Rather than holding your breath through down markets and breathing in relief when returns are positive, I recommend actively managing the downside. You can do this by building your portfolio with the objective of losing less when the market declines and tracking market returns during upswings. By losing less on the downside, you don’t need to gain as much back to start performing again when the market turns around.
Why does this matter? It is much harder to climb out of a hole than it is to climb into one. To illustrate this point, think back to 2008, when the S&P 500 dropped about 37 percent. In order to return to its previous levels, the S&P 500 did not need to rise by 37 percent – it needed to climb about 59 percent! As percentage losses get larger, the required gain to break even increases, such that a loss of 50 percent would require a gain of 100 percent to get back to your original starting point. As you can see, it might just be better to manage the downside to begin with!
I recommend using diversification and active management together to help you do just that. Diversifying your risk exposure among different asset classes will hopefully diminish the effect of any one of them on your overall performance. You could also explore alternative assets, which tend to be less correlated or even uncorrelated with stocks and bonds. Active management is the other part of the equation: be sure to keep an eye on changing business conditions and the economic environment. These factors can affect the broader risks you face as an investor. In a perfect world, this combination of diversification and active management would come close to eliminating volatility on the downside while allowing for market-tracking returns on the upside. However, even modest reductions in volatility can go a long way towards helping guide your portfolio through bad times while still keeping up with the good.
The other key to managing risk is to plan your time horizon appropriately. Volatility will happen, and part of the benefit of exposing yourself to risk is the potential to gain more over the long run. Investing for a broad time horizon, as you would in an IRA or 401(k) account, requires that you to keep those far-off goals in mind and take a philosophical approach to short-term market downturns. It simply takes time for the markets to recover from a bad year. For example, based on historical S&P 500 data from 1970 to 2009, there’s only a 34.2 percent chance that you could recover from a 35 percent loss in three years. However, over five years you’d have a 57 percent chance of full recovery. Remember: losses can occur quickly, but recovery takes time. And the long-term performance of the market is in your favor, as the S&P 500 has an annual average return of 9.9 percent since 1970.
Managing for the downside is a balancing act: You want to balance the short- to medium-run economic outlook with your long-term goals, and you want to reduce risk without losing exposure to it. At the heart of this strategy should be a clear understanding of who you are and what you need. How do you handle risk emotionally? What is the time horizon on your account? Also be sure to understand your advisor or money manager’s thought process when it comes to your portfolio. Does he or she have an understandable philosophy behind their decision-making? Are they able to answer questions about volatility by providing information about your portfolio, including its standard deviation?
By spending time thinking about and actively planning for the downside, you might find that facing risk becomes a bit easier. Knowledge is power, and knowing about risk and how to take advantage of it will help you to build a portfolio that is a better fit for you, and hopefully a better performer!
For information about managing your IRA or a 401(k) rollover, download my free eBook, “10 Tips You Need to Know About Your IRA Rollover”. This short book is packed with critical information that will help you make the right decisions about your retirement savings.
Written by Bradford Pine
Bradford Pine Wealth Group – New York City Financial Advisors
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