When I sit down with new clients to discuss their financial goals, one of the most important parts of that conversation is how much risk they are comfortable taking. 9 times out of 10 the answer is somewhere along the lines of normal risk, or medium risk. The only reason I get this answer is because people don’t want high risk, and they know they need more than low risk. Oftentimes this is just the answer that makes the most sense to them, but they really don’t have a good understanding of what risks investing entails.
Today, I’m going to go over the three primary risk types of a properly diversified portfolio. I want to highlight the properly diversified portfolio part. If you are out there picking your own stocks, or you have a 20 stock portfolio, this is not applicable to you. Those portfolios are poorly diversified and have a magnitude of additional risks, with no additional upside. The three primary risk types of a properly diversified portfolio are: Economic Collapse, Emotional Capitulation, & Sequence of Returns risk.
Let’s start with the easiest to understand, and also the one least likely to matter. Economic Collapse. This risk is that something so major and powerful happens within the economy that you see the stock market & bond market effectively fail or drop to 0 in value. Believe it or not this is something a lot of people worry about. “What if I lose all my money???” The only way to lose all of your money is to have the market drop to 0 in value. The only way this could happen is if we have such a major event that capitalism collapses. With it, the North American economy, Europe, Asia, etc etc. This risk isn’t worth worrying about, purely because if this does play out nothing is going to have value anymore. Had you kept your money in the bank, under your mattress, or in gold bars, it wouldn’t matter. People will be fighting for survival and food and weapons will easily be the most valuable resources. In other words, if this happens, you’re screwed, but so is everyone else and there is nothing you could have done to avoid it. Only the doomsday preparers come out ahead in this scenario.
Now, Emotional Capitulation. This is the one that impacts everyone and is the single largest risk of any investment portfolio I have ever worked with or seen data on. It can be thought of in two ways. The first, is just how your emotions get involved in your portfolio and drag your returns down. Such as seeing your strategy under-perform for 3 years and deciding to change to the strategy your buddy Dave is using because he’s done well over the last 3 years. Effectively selling low and buying high. The second, is the big one. During a major market crash getting scared, or trying to time the market by selling out. No matter how often we discuss this risk with clients, it rears its ugly head during every major market event. The market is in free fall and you think you can hold on. Down 20% and you start getting nervous, but you know you need to ride it out. Down 30% and you start panicking and feeling sick to your stomach. Down 35% and you can’t take it anymore and sell. You’ll wait for this to settle then buy back in at the bottom. Except it never happens. Even the most prudent financial minds in the world can’t pull that off. Everyone has a point where they can’t take it anymore and they will sell. You have to do everything you can to determine what this capitulation point is and make sure your portfolio is designed to never get there.
Finally, Sequence of Returns Risk. This risk is only applicable to those who are drawing on their assets. If you aren’t withdrawing from your investments, then this risk will not apply to you until you do. This risk is the risk of having worse investment returns at the beginning of your draw-down phase vs the end of the draw-down phase. The order of your annual returns makes a significant difference in probability of your portfolio reaching its goals. Let’s look at an example to show how this works, we will start with $100,000 and draw out $5,000 at the end of each year for 10 years
Both of these portfolios had an average return of 4.10% over the 10 year period. Yet the portfolio with the lower returns first, ends up substantially worse off. An investor that didn’t withdraw at all, would have seen the exact same growth to $149,432 in either scenario. This highlights the risk that the sequence of the returns can have. Being aware of this risk is fundamental to achieving most retirement goals and objectives. At the end of the withdrawal period, the portfolio with the good returns first, had nearly double the amount left in the account compared to the bad return portfolio.
Now the good news. There is a way to avoid each of these types of risks and ensure that you don’t sacrifice your financial health to any of them. Unfortunately this article is too long now.
As such I’ll explain them all in three more posts: