The Planner's Perspective: When? Who knows?
By Paul Morrone CFP®, CPA, MSA
The risk/reward tradeoff has been around as long as life itself and relates to every decision an individual must make. While most decisions we are faced with daily involve a negligible amount of risk (do I have a salad or a sandwich for lunch, for example), other higher-risk decisions may have outcomes lasting months, years or decades (as in what home am I going to purchase). Applying risk management to a portfolio of investments is more art than science, as for many their appetite for risk changes more rapidly than it should. Investors who define themselves as conservative now find themselves willing to go a little further out on the diving board in fear of ‘missing out’ on what is left during a hot market. But when is the run going to end?
Individuals tend to assume more risk in bull markets, and less risk in bear markets. Sounds great in theory, enjoy the ride up while protecting the downside. Except the major flaw here is determining when one event ends and the other begins. Get out too early and the opportunity cost can be severe, get out too late and the bottom has already fallen out. When do we pair risk down in preparation for a bear market, when do we take on more risk to enjoy the benefits of a bull market? The answer of course is impossible to come by.
A strategic allocation should be designed to withstand both bull and bear markets, meaning that the amount of risk in the portfolio should remain relatively stagnant regardless of whether economic and capital market conditions are favorable at any given moment. While this may produce a bumpy ride at times, it is not designed to be viewed in a vacuum or changed daily. Target, or strategic, allocations are designed to withstand the test of time and be evaluated over an entire market cycle, which could be decades. Statistically, long-term investors who stay the course through good times and bad fare far better then those who try to time the market and sell at highs and buy at lows.
While it is prudent to evaluate your risk tolerance on an annual basis, in general there should not be material changes from year-to-year. Life events are often the largest driver in changes in risk tolerance, which generally should not be made in reaction to news that you see on TV or read online. Changes in time horizon (i.e. when you’ll need your money), investment objective (growth vs. income), health or lifestyle (retirement) are often indicative of reasons to make material changes to your portfolio. The most important thing to remember is to separate yourself from the noise generated by day-to-day life and understand how your finances fit into the big picture. Chances are that your assets will remain invested through numerous presidential terms, international conflicts, bear markets and any other type of uncertainty you can think of. Keep yourself laser focused on the fundamentals of why you are invested, instead of why you shouldn’t be.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Asset Allocation does not ensure a profit or protect against loss.