It can be turbulent for anyone investing in the stock market. We’re all re-learning that our investments can go down as well as up and it’s unsettling.
As you watch your 401K balance swing to and fro, it’s a good time to think about risk. It’s an abstract concept but we certainly know when we feel it.
I’ll make three observations about risk in your investment portfolio and then offer some practical suggestions:
1. Risk is linked to expected returns. Higher expected returns can only be achieved by incurring more risk. Don’t fight this as it is as true and universal as the law of gravity. Keep in mind that if you take more risks, you aren’t necessarily entitled to higher returns. Foolish risks are still foolish.
2. Your time horizon changes risk. What seems intolerably risky in the short term can feel safer over a longer time horizon. I looked at stock price returns beginning with the 1920s and counted the number of time periods in which the stock market had a negative return:
- 1 month: 40%
- 1 year: 28%
- 10 years: 3%
- 20 years: 0%
If your time horizon was only one month, you would have experienced a loss 40% of the time. However, there has not been any 20-year period at the end of which stock market returns have been negative.
For those of you with memories of the more recent crash in 2008, the stock market has been up every year since then. It took about six years for the S&P 500 to exceed the high it had previously reached in 2007.
3. Diversification reduces risk. Most of us understand not to put all our eggs in one basket. You want to combine assets that have dissimilar patterns of returns — each should be a good investment on its own but ideally, their up and down trends are different from each other.
A simple example is a sunglasses shop at the beach. If you add ice-cold lemonade to your offerings you won’t get much diversification to protect your revenue on cold and rainy days but if, instead, you branch out with umbrellas and hoodies, you could do a brisk business in any weather.
This is why investing in different assets such as international stocks, junk bonds, small companies, and commercial real estate makes sense. Each asset class may be risky by itself, but combining them dampens the overall risk of the portfolio without diminishing the expected returns.
So, what are the practical implications of these three observations?
1. If it seems too good to be true, it is. Stay away from hot stock tips, your brother-in-law’s new restaurant concept, racehorses, and bitcoin. These are the foolish risks that are not compensated with higher expected returns.
2. Don’t buy individual stocks and bonds. You’re incurring unnecessary risk by being undiversified. Instead, focus on the appropriate asset allocation — i.e., the mix of stocks, bonds, international securities, etc. — that makes sense for your risk tolerance and time horizon. Once you decide what asset allocation is right for you, invest in low-cost mutual funds for each asset class.
3. Don’t try to time the market. It’s a fool’s errand that will end in misery and regret. And, you need to be right twice — once when you decide to get out and then again when you decide to get back in. Good luck with that. To quote Warren Buffet, “The only value of stock forecasters is to make fortune tellers look good.”
4. Take more risk when you’re younger. This is sensible for two reasons. First, you have more years of earning an income that can act as a “ballast” against the choppier returns of your investments. Second, you have the luxury of a long time horizon.
5. Take more risk when you have a higher income or more savings. This is intuitive for reasons similar to #4. You have more of a cushion to absorb the losses when the inevitable down periods come.
6. Minimize investment expenses. These are the fees you pay to own mutual funds, trade stocks, and engage an advisor. It is a zero sum game so the more expenses you incur, the less you keep for yourself. Over long periods of time, these small fees substantially reduce your wealth accumulation.
7. Lastly, if you’re stressed, don’t view your account balance. If you’ve followed my advice on #s 1 to 6, there’s no need to check your 401K. Let it go and focus on something in your life you can control.
Questions about your asset allocation and investment strategy? Please get in touch.
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