A 4-letter word - RISK
Now that I have your attention, let’s focus on something that all investment portfolios have – R-I-S-K. In financial terms, risk is exposure to loss which is related to the expected return of an investment security (for example, a stock or bond). It is important to consider risk when adding any security to your portfolio. The Capital Asset Pricing Model (CAPM), a theoretical model of the relationship between risk and expected return, suggests that investors demand larger investment returns for taking greater investment risks. Makes sense.
All stocks and bonds in your portfolio face some form of risk. In the case of stocks, we see two types of risk: systemic and non-systemic risk. Systemic or market risk relates to changing conditions in the economy, such as the business cycle, inflation, or monetary policy. Because the market is inherently unpredictable, systemic risk is always present and cannot be reduced through diversification. The only way to completely avoid market risk is not to invest in stocks. Non-systemic risk, which includes sector-specific and firm-specific risk, can be diversified through appropriate asset allocation and stock selection strategies.
How about I just invest in bonds, that way I can avoid risk completely? Sorry, it doesn’t work that way. Fixed income securities, like bonds, have several types of risk including default risk and interest rate risk. Default risk is the possibility that a borrower (a country, government agency, bank, municipality, or company) will default by failing to repay principal and interest in a timely manner. Interest rate risk is the risk of falling bond prices due to a rise in market interest rates. For bond investors, 2022 saw the worst performance in over 45 years as an aggressive Fed raised rates throughout the year in its battle against historically high inflation. For the year, the Bloomberg US Aggregate Bond Index fell over 13%.
Risk tolerance refers to our investing psyche and ability to remain unaffected by market volatility. It is important to develop a psychological detachment that is present in both bull and bear markets. If you are like me, you probably enjoy checking your stocks during good times and try to avoid the business section during bad ones. History instructs us, however, that good investing opportunities often present themselves in the meanest of bear markets.
What risk profile is most suitable for you and your family? How much risk do you need to accomplish your investing goals? You need some risk to increase the probability of higher investment returns, but not too much that you unwisely damage your chances of retiring on schedule. Do you consider yourself to be a conservative (less than 20% stocks), balanced (50% stocks and 50% bonds) or a more aggressive (over 80% stocks) investor? To answer this question, we suggest that you consider how your peace of mind is affected by market volatility. What is your threshold for pain or said another way, when will stock market losses keep you up at night?
A simple rule might be that if you were to subtract your age from 100, your answer would be the percentage of stocks in your portfolio. Thus, at age 40, your stock allocation might be 60%. The important point here is not the starting point, but the recognition that at age 60, your stock allocation should have decreased to 40%. Taking some risk off the table as we move towards retirement makes sense. This is overly simplistic, but it demonstrates the point that for most investors, age and stock allocation percentage within our portfolios are inversely related. The shorter our investing time horizon (when we need our money), the less risk we should be willing to take in our portfolios.