We are all bombarded daily with warnings about the risk of investing. Buying yesterday’s hot stocks. Losing your money on crypto. Crazy Uncle Harry’s is not to be missed, downstairs opportunity.
A more technical definition of risk is the chance that an outcome or the outcome of an investment will differ from the expected outcome or return. If you’re one of the few people who study fund fact sheets, standard deviation is often used as a risk metric. It looks at volatility compared to historical averages over a given time period, say one, three, five, or 10 years. Put another way, it’s how much a given investment rises or falls over time, which can be a useful way to track investment risk. Other investors think the risk is that their fund or adviser will miss an arbitrary index of values, such as the Dow Jones Industrial Index or the S&P 500 Index.
We question both definitions of risk. The risk is not below an index; It is not up to its goals. Does it really matter if your performance lagged 10% or 15% of the broader market in a year vs. realizing that, based on a lifetime’s savings, you’ll run out of money when you retire?
The risk starts with you
No two clients at our firm are the same. Experience shows that an investor’s ability to accept investment risk depends on many factors, including family history, personality, lifestyle or age. Because it is so critical to the financial planning process, defining risk is not as easy as it seems.
Before you can consider risk in your portfolio, you must identify your objectives, based on your individual circumstances and what you want to achieve with your money. Possible targets may fall into one or more of the following groups:
You’ve worked hard, saved, and done well in the markets, and you’re looking for self-sufficient wealth.
You want discretionary wealth – the ability to freely enjoy what you have accumulated.
You may be interested in passing the wealth on to your children or future generations.
You may be interested in using philanthropy as a force for good in the world.
These scenarios have very different emotional drivers, timelines, and risk factors. For example, if you are in the accumulation phase, you may be more concerned with financial security (“Will I be okay?”), but if you are at the higher end of the wealth spectrum, you may be more concerned with manage increasing complexity in your life (“What am I missing?”).
After setting goals, the next step is to wrap them in a carefully constructed investment strategy to increase the chances of success and minimize potential risks. Those risks have nuances. Risk tolerance is the amount of risk you must take to achieve your personal goals, which are based on your unique situation. But this must be balanced against your risk capacity – how much risk you can afford to take.
Someone with a high level of wealth may have a higher risk capacity than someone with less money to risk. If a drop in the value of your investments causes you to reduce your lifestyle below a comfortable level, you’ve exceeded your risk capacity.
Four risk factors to include in your financial plan
So here’s how we think you should define risk: not that markets go down or up, but whether you’re likely to miss your targets. Risk, by its nature, deals with four unknowns that must be managed in the planning process.
Longevity
No one knows for sure how long you will live, so any financial plan must consider your life expectancy. In the financial plans we prepare for clients, we routinely project life expectancies of at least 90 years. There are a number of strategies you can use to reduce the financial risk of dying early and provide a more secure future for your family.
Inflation
Sustained bouts of inflation can wreak havoc on your investments, as we’ve seen over the past year or two. While it’s nearly impossible to fully insulate your portfolio from inflation, having a well-diversified core allocation across stocks and bonds could help you navigate inflationary periods. Rising prices can be especially good for stocks, if the underlying companies can raise their prices without losing business. Another way to help you stay ahead of inflation is to add asset classes that are not as sensitive to inflation or rising interest rates to your investing toolkit.
market returns
No one can consistently predict where the stock or bond market will be a month, six months, a year, or three years from now. Rising stock markets require strong earnings growth to keep valuations up, and earnings in some sectors have come under pressure recently. However, history shows that over rolling time periods of 10 or 20 years, stocks have almost always gone up. If you have the benefit of a long-term investment horizon, you can reduce market risk by constantly saving and investing and sticking to a sensibly constructed financial plan. (Past performance is not a guarantee of future results.)
Fiscal policy
Fiscal policy rarely remains static or predictable. State and federal income taxes, property taxes, and estate taxes affect how much of your money you keep. We recommend diversifying your assets by tax location, which can help you improve your financial position, whether taxes are high or low.
The opinions expressed in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Bruce Helmer and Peg Webb are financial advisers to Wealth Enhancement Group and co-hosts “Your Money” on WCCO 830 AM on Sunday mornings. Email Bruce and Peg at [email protected]. Securities offered through LPL Financial, member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, LLC, a registered investment adviser. Wealth Enhancement Group and Wealth Enhancement Advisory Services are separate entities from LPL Financial.
