Executive Summary
- Investors are required to incur some amount of investment risk if they expect positive returns from their investments
- In understanding their risk tolerance, investors need to analyze both their capacity to take risk, and their willingness to take risk
- When capacity and willingness to take risk are misaligned, investors need review their financial plan with their financial advisor to reconsider either their goals or their portfolio structure
- Markets are resilient, and often recover quite quickly from drawdowns; divesting at the bottom of a drawdown means leaving higher future expected returns on the table
While investing, in practice, is complex, the ideas that inform your financial plan should be simple.
Risk and return are intrinsically related. For an investor to grow their capital to achieve a future goal, like funding retirement or buying a vacation house, they are required to assume some level of risk. While investing to achieve a goal is ubiquitous, every individual’s financial situation and emotions about investing are unique. The amount of risk investors can afford, or in some cases, need to take, is their capacity to take risk. This risk capacity is measurable, and it is based on the investor’s current financial situation and their investing goals. An investor who is close to retirement temporally, but far from their retirement savings goal will require a higher rate of return, and, in turn, be required to incur greater investment risk, than an investor who has saved diligently and has a longer investment time horizon. In many cases, this means the investor requiring a greater rate of return will invest in a portfolio with greater exposure to riskier investments, like equities. With a greater allocation to risk assets, this investor should expect more frequent drawdowns in their portfolio. We are currently experiencing one such drawdown. Using the S&P 500 TR Index as our proxy, US equities are down nearly 24% year-to-date through 9/30/2022, surpassing the 20% threshold that many use to define a Bear Market.
While drawdowns, like the one we find ourselves in during 2022, are often uncomfortable for investors, they should be viewed as ordinary events for portfolios that take on investment risk. Drawdowns are a direct characterization of the risk you need to take to grow your money to achieve your goals. Despite many opinions to the contrary, most empirical evidence suggests that investors are unable to systematically time the market. In fact, in pursuit of market timing, most investors degrade their long-term return. Given these facts, the best plan of action during a drawdown is to make no changes to portfolios knowing markets are resilient and will recover. The table below shows prior instances of 20% drawdowns in equities and subsequent performance.
As you can see, significant drawdowns occur frequently, with many investors experiencing numerous drawdowns of 20+% over an investment lifetime. The important lesson is that while drawdowns can be fierce and discomforting, markets often rebound quickly and in a meaningful way.
That said, just because your financial plan indicates that you have the capacity to incur these risks and still have a successful investment experience, capacity is not the only consideration in assessing risk tolerance.
The other aspect of risk tolerance is your willingness to incur risk. When an investor’s willingness to take risk does not align with the level of risk they need to take to achieve their goals, they are left with two options:
1. Adjust their goals to levels that can be met with lower risk portfolios
2. Adjust their expectations to tolerate risk while remaining in the appropriate portfolio in terms of risk capacity
Investors choosing to pursue option 1 should realize that adjusting their goals could involve living off less money in retirement, buying a smaller house, or have other material consequences on one’s quality of life. Investors looking to make rash decisions after large drawdowns should also know that, as markets draw down, expected returns go up. This fundamental relationship should be understood and appreciated before making any portfolio allocation decisions, as going to cash or shifting to less risky assets after a drawdown can have compounding negative effects by realizing losses, or lower gains, and foregoing potentially higher future returns. In other words, given that you have already incurred the downside aspect of your portfolio’s risk, changing your portfolio now would be also leaving before incurring the rewards.
In summary, achieving your financial goals involves incurring some amount of risk. Your capacity to take that risk informs the portfolio to best help you achieve your goals. However, risk is not a nebulous concept, it exists in the form of volatility and drawdowns that you should expect to experience during your investment horizon. If your tolerance to take risk is misaligned with your capacity, consider reducing your goals to ones that can be achieved at lower levels of risk or consider adjusting your expectation to make it easier to weather the storm. As markets fall lower, expected returns go up, and, as always, the best time to invest is now.
Glossary
The S&P 500 Index is a broad market sample based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. For more information please visit the following link
Disclosures
This material is for informational purposes and is intended to be used for educational and illustrative purposes only. It is not designed to cover every aspect of the relevant markets and is not intended to be used as a general guide to investing or as a source of any specific investment recommendation. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. This material does not constitute investment advice, nor is it a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. In preparing this material we have relied upon data supplied to us by third parties. The information has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made by Altafid, PBC or its affiliates, as to its accuracy, completeness or correctness. Altafid, PBC or its affiliates do not guarantee that the information supplied is accurate, complete, or timely, or make any warranties with regard to the results obtained from its use. Altafid, PBC or its affiliates have no obligations to update any such information.
