The recent announcement about the tariffs that President Trump plans to levy against other countries came as a surprise to many, including our closest trade partners. Financial markets don’t like surprises, so global markets tumbled in response to the announcement. The big question is whether the tariffs will be temporary or permanent, and the answer to that question is unknown.
So how is an investor to react?
Whether it is a tariff, a pandemic, inflation, or interest rate spikes, many factors can cause the stock market to drop 10-20% in value in any given year. As we mentioned in our first article in this series, we have a bias towards long-term investing and away from short-term trading. The key for long-term investors is to recognize that this is part of the process, to recognize how much you can handle, and to use risk well in your portfolio.
You have probably heard the term “risk tolerance,” and you may even have a good innate understanding of your own perceived tolerance. But is your portfolio actually matched to you as an investor and what you want your money to do for you? If the normal, healthy ups and downs of the stock market are too disruptive for you, it’s possible that you should dial down your risk. On the other hand, we sometimes see investors who can stand (and possibly benefit from) more risk than their portfolio reflects. If that’s you, we would challenge you to ask yourself if you are taking enough risk in your long-term money. Below we will teach you how to assess the level of risk that’s right for you.
Risk Tolerance – In the investment world, risk tolerance is a combination of your emotional fortitude to take risk + your capacity to take risk. Some investors focus just on the first part – the “can I stand to stay invested through this volatility” part. Many factors can influence your emotional fortitude, and your acceptance of risk may change throughout your life. For example, if you won’t use your money for thirty years, you may have a higher risk tolerance than someone who is using their money now. Life events can also alter your fortitude: it may rise with a job promotion in a strong economy, and fall with a job loss in a recession.
If the stock market drops 5% and you consider selling your investments, you have a fairly low emotional fortitude for risk, so the amount of stock you hold may need to be lower than another investor with the same risk capacity as you. If the stock market drops 20% and you consider investing more, you have a high fortitude, and you may benefit from having a high level of stock in your portfolio over time. It’s important to check in on your emotions about risk on a regular basis, but it’s also important to remember this is just one component of true risk tolerance.
Risk Capacity – This is how much your financial assets can drop in value and still serve your needs. In a wealth management firm like ours, we start with the financial plan. In simplified terms, this means we develop a model that incorporates our clients’ assets, liabilities, and goals. This model dictates the type of investments that are appropriate to achieve goals in a given timeframe. A business owner who is in a high-risk sector or in a growth phase with their company may not be able to weather a significant market downturn in her personal portfolio. However, a 45-year old executive with a high income and substantial corporate benefits may benefit from investing cash during a market decline, especially if his goal is maximum wealth accumulation.
Risk Necessity – This is how much risk you need to take to achieve your financial goals. An investor who wants to earn an 8% average rate of return in her portfolio to achieve her wealth accumulation goals will need to have a high level of stock in her portfolio. However, an investor who has accumulated enough wealth to be financially independent and has a goal to preserve, as opposed to grow, his investments does not need to be exposed to the stock market at a high level. If he is happy with a return of 3-4%, he could even consider investing in money markets, bonds, and fixed interest rate investments in today’s environment and avoid the stock market altogether.
Risk Stack – Once we identify our clients’ risk tolerance (emotional fortitude + capacity) and risk necessity, part of our process is to develop a risk stack: layers of assets that are assigned to meet various needs at different points in time. With a foundation of stable funds (think savings and money markets) for near-term and emergency needs, we increase the risk in varying amounts through investments in bonds, stocks, hedged assets, private assets and alternatives for longer term needs.
Once your risk stack is in place, your wealth and your intentions should be well-aligned. As that is achieved, normal market volatility shouldn’t shake your confidence in your long-term potential to be financially successful.
This is the second installment of our four-part series to help you focus on key elements of your investment portfolio. We addressed our five-step process to look at your portfolio (purpose, time horizon, expenses, taxes, and risk/reward potential) and provided a deep dive on risk. Our next installment will offer strategies to help you find value in a market downturn. We will wrap up the series with some historical perspective about market volatility. If you have any questions you’d like us to address in this series, you can send them to hello@bfsadvisorygroup.com. And if this article causes you to think of others in your life who would benefit from seeing it, please don’t hesitate to share it with them. We want to help as many people as we can during this challenging time.