Many investors are completely unaware of the amount of inherent risk in their investment portfolios. My job is to make sure you aren’t caught unprepared for the next gut-wrenching market correction. Now is the time to ask the question “How far can your investments drop in the next market correction?”
As I write this article, we have not had a significant market correction since the 2007 – 2009 financial crisis. That is almost eight years without a loss of 20% or more. This is a very good time to take a look at how much money your investment portfolio could lose when the next downturn occurs.
Once you understand how much of a loss your investments could experience, it is important to decide if you can or cannot tolerate that loss.
What do I mean by risk tolerance?
The risk is not the variations we all experience in the daily, weekly and monthly gyrations of the typical stock market. Rather, it is how much your investments are going to drop the next time the stock market loses 40% to 50% of its value? That is what I call risk.
How do you react to risk?
Think about how risk affects you. Most people are much more loss averse than they are motivated by possible gains. Given the choice of heads or tails single flip of a coin: heads you win $200 tails you lose $100. The majority of people will not take that bet even though they have a fifty-fifty chance of doubling their money.
Everybody has their comfort levels or limits with risk, and you need to understand what your limits are before a correction occurs. One of the biggest mistakes you can commit is to make adjustments to your portfolio after the market is in the midst of a correction.
How do you measure your risk tolerance?
There are many ways to measure your risk tolerance. Over the last several decades there have been countless questionnaires that attempt to measure this. These questionnaires have spanned from dozens of questions all the way to a simple single question such as “On a scale of 1 to 100, what is your risk tolerance?”. Most of them have been pretty useless.
For years, financial advisors have relied on their experience and one-on-one discussions with clients to help them determine a client’s risk tolerance. This method is far from perfect. One downside to this approach is that you (the client) may end up not actually understanding how much risk you are exposed to or why you are exposed to some degree of risk. This method is also subject to the advisor’s own biases and may not truly reflect your beliefs. People tend to hear what they want to hear.
Typical market fluctuations don’t count
Advisors can gloss over the severe downturns and concentrate conversations on the regular market fluctuations that you will experience 95% of the time. This does not prepare you for the gut-wrenching returns you will see the other 5% of your time as an investor. You might recognize this when your advisor refers to two standard deviations of your portfolio. Forget standard deviations. We just use that to make ourselves look smarter than we are. The 2007 – 2009 financial crisis was five standard deviations from the norm. What does that mean in statistical terms? It means it should never have happened. Oops, it did happen.
Have you ever heard the phrase “Black Swan” event? Nassim Nicholas Taleb coined the phrase in his book The Black Swan: Impact of the Highly Improbable. The phrase was popularized after the events of the financial crisis. This concept is quite simple: There are very few black swans in the world compared to white swans. So few, statistically speaking, you should never see one. The thing is, black swans do exist, and people encounter them every day. Events like the 2007-2009 financial crisis are black swan events. Just because they are completely unpredictable and rare doesn’t mean that we shouldn’t plan for them. These are the events that can cause you to abandon your financial plan at exactly the wrong time.
What are the three things that make up an excellent risk analysis?
- Use actual dollar amounts not just percentages.
If you have a $1,000,000 portfolio, it is one thing to say your portfolio can go down by 20% to 40% in any given year. It is quite another to say you can lose $200,000 to $400,000 of your portfolio in any given year. Don’t just talk regarding percentages and standard deviations, use actual meaningful dollar amounts. Are you going to be okay if you lose this amount of money from your portfolio? Are you capable of making the adjustments necessary to your income and lifestyle if, or when, you lose that much money in your portfolio?
- Make sure you understand what the typical fluctuations of your portfolio are.
This is where the plus or minus two standard deviations come in. If you want to understand standard deviations and how they relate to your investment returns, Wikipedia has a decent explanation. 95% of the time your returns will fall within certain levels at two standard deviations. This is a good range to know and get comfortable with. It is not by any means sufficient for you to decide on your long-term investment plan. Two standard deviations are just the “don’t worry about it” range. It’s the other 5% of the returns that cause investors to make detrimental decisions at the exact wrong times.
- Use historical events to frame your possible losses.
These are the other 5% of the returns. Pick a point in time that you are familiar with, better yet, even lived through. Find out what would have happened to your portfolio during that event. The financial crisis is a great timeframe to consider. From October 15, 2007, through March 2, 2009, the S&P 500 Index lost 53% of its value. What would your current investments have lost during that period? Can you live with that loss if some similar event happens again?
What should you do next?
Get with your advisor and make sure you understand what level of risk your portfolio is subjected. We use FinaMetrica for our questionnaire. If you would like take the quiz, then we would be happy to talk you through the results with absolutely no obligation.
If you would like an objective second opinion on how your portfolio will perform during the next market downturn, please contact us for a no-obligation analysis.