As the major indices continue to bounce around near all-time highs, many investors are beginning to talk again about risk and the impact that a sharp market drop could have on their portfolios.
After all, what if I invest today when the market is at the top and it drops? Shouldn’t the risk of that possibility keep me out of the markets until a safer entry point?
While this concern is certainly not new, it also seems to suggest a shortsighted and narrow view of risk. After all, if risk is simply defined as a drop in the markets after I am already invested, then that inevitably leads to an “all-in” or “all-out” market timing mentality that has proved elusive to even the most nimble and savvy investment professionals.
[See: The Best ETFs Retirees Can Buy.]
Further, if fear of a market drop is the narrow definition of risk, how is one to plan for a retirement of 20 to 30 years or even more? After all, history shows the markets are cyclical, so this means that market drops during a saver’s retirement are almost certain. Is that really risk, or is it a fact of life that should be incorporated into a comprehensive plan?
Young savers are often characterized as more risk tolerant due to their age, number of years until retirement, belief that their incomes will be rising as they progress in their careers, etc. Further, they have the eighth wonder of the world on their side, the power of compounding, which can help them earn even more savings on their savings than an investor with a shorter time horizon.
For these and other reasons, advisors often counsel younger savers to take on more risk during early savings years and invest regularly (i.e., dollar cost average). This practice helps the inevitable market swings become their allies and allows them to purchase more shares as prices drop and fewer shares as prices rise.
Such systematic investing helps remove the guesswork, emotion and timing from investing, and helps keep the saver committed to a plan no matter what the headlines say. As the investor ages and their personal situation changes (perhaps through marriage, illness, promotions, etc.), they can adjust their risk tolerance.
Accordingly, how should this investor define risk? Are they investing more money than their monthly expenses permit and thereby finding themselves going into high-interest debt to fund their investment savings? That would seem to be real risk — since the accumulation of high-interest debt can bring dramatic harm to one’s credit rating and savings ability.
[See: 8 Investing Tips for New College Grads.]
With these considerations, market risk isn’t necessarily the most significant factor.
The personal index. Our industry has done a disservice to savers by narrowly defining risk and outcomes by measuring both against the major indices. “Beating the market,” whether on the upside or downside, is the mantra for many, when in fact we believe we need to reframe the risk narrative to address how investors are really impacted. Will they have sufficient savings to retire on time? Do their investments generate enough cash flow to pay their bills and travel in retirement?
Far more than merely being ahead or behind the year-to-date performance of a market index, aren’t these really the ways most investors measure success? If so, does it really matter at any point in time whether an investor is beating the index? Each investor should ask: Is my financial plan helping me stay on track to achieve the specific goals inherent to my needs and wants? If I cannot do the things I planned because my financial plan didn’t anticipate gyrations in the economy and markets, why compare my returns to an arbitrary benchmark? My personal index is the only one I want to meet or exceed.
This brings us to the question of whether there is a more practical definition of risk. We would submit that perhaps the biggest risk to most investors is not having cash when you really need it. After all, the world isn’t simply made up of growth investors and income investors. We are all saving so that we have income when we need it most, whether now or in the future.
Achieving any market victory would feel both meaningless and empty if we could not pay rent, tuition, taxes or health care bills.
Creating a plan. A financial advisor can help to form a plan that is unique and particular to an investors’ needs, wants and dreams. Properly crafted, this plan can be thought of as a distinct personal index that incorporates the identified goals which investors have for their life.
Creating specific, objective-based buckets within the investment portfolio allows these plans to be funded when needed. Because investors come in all shapes and sizes, financial plans should be customized. Far more than a simple asset allocation pie chart derived from an investor questionnaire, each plan should incorporate the timing of needs as well as the relative importance of each goal.
[See: 8 Times When You Should Sell a Stock.]
Creating a personalized plan and index allows investors to take risk into their own hands, allowing future needs, wants and wishes to potentially become reality.
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Risk: A Fresh View of How We Should Define It originally appeared on usnews.com
