With U.S. stocks at all-time highs, now is the perfect time to review your risk profile and then make sure the asset allocation within your investment portfolio matches it. Equity markets have been on a tear. In 2017, the average diversified US stock fund returned 18%, while the average international stock fund returned 27%. In the first three weeks of 2018, the MSCI World Index of stocks has increased 5.6%. With low interest rates and inflation, accelerating growth and the recent passage of the Tax Cuts and Jobs Act, it looks like this streak could continue in 2018.
During the current nine year bull market, investor emotions about stocks have gone from optimism to elation and many investors now are not only complacent, but overconfident. Yet, with valuations soaring, we are approaching the point of maximum financial risk. Certainly, at some point, we will have a pullback, correction or crash.
It always happens. It could be a conflict in N. Korea or Iran or somewhere else. It could be a worldwide health scare. It could be higher interest rates negatively impacting our rising national and personal debt. It could be something none of us even consider today. History shows it will happen. We need to be ready for it by having an asset allocation in our portfolios that matches our risk profile.
What exactly is a risk profile? There are three components of your risk profile. First, your risk capacity, or ability to withstand risk. Second, your risk tolerance, or willingness to accept large swings in investment returns. It’s the way we are hard-wired to respond to volatility. Third, your risk perception, or short-term subjective judgment about the characteristics and severity of risk.
We classify your risk profile into one of five categories of risk: defensive (very low), conservative (low), balanced (moderate), growth (high) and aggressive (very high). As a general rule, younger investors are more willing to take on a higher level of risk. However, that’s not always true. Investors in their 80s and 90s who know that they have ample funds for their lifetimes and beyond, and who can emotionally handle high risk, may have an aggressive risk profile, particularly when they plan to leave most of their money to the beneficiaries. Everyone’s circumstances and emotions are different. Profiles can change over time, particularly when there are life changing events, such as marriage, birth of a child, loss of job, retirement, changes in health or other matters. Therefore, it’s important to regularly assess your risk profile.
Here’s the process:
Step 1. Quantify your lifetime monetary goals and compare those with your expected lifetime assets. During your accumulation years, how much will you add to your retirement funds per year? How many years until retirement? How much money will you need to withdraw annually during retirement for your needs, wants and wishes? What are your sources of retirement income? What’s your realistic life expectancy? What market return is required to provide the likely outcome of success- not running out of money? Do the goals require a high rate of return just to have a chance of success or is the goal so low risk that even a bad market outcome won’t cause it to fail?
Risk capacity isn’t simply the amount of assets you have; rather it is the comparison of those assets to your expected withdrawal rate from your portfolio. A low withdrawal rate from your portfolio, e.g. 1% or 2% a year, means you have high risk capacity. A high withdrawal rate, such as 6% or more, means you have low risk capacity.
Step 2. Evaluate your tolerance for risk. What’s your comfort level with volatility? Are you aggressive? Moderate? Defensive? How does that compare to the risk needed in your portfolio to meet your goals? If the risk needed to meet your goals exceeds your risk tolerance, you need to go back and modify your goals. On the other hand, if your risk tolerance exceeds the risk level to meet your goals, does that mean you need to take on more risk just because you can or because you can afford it? You need to go through the numbers and make important decisions.
Step 3. Compare the risk in your portfolio to your risk tolerance. Separate your assets into all three classes: equities, fixed income (including cash) and alternatives and determine your asset allocation. A balanced portfolio might have roughly 50% equities, 25% fixed income and 25% alternatives. An aggressive (very high risk) portfolio could have 80% equities and a defensive (very low risk) portfolio might have only 10-35% equities. If your portfolio is riskier than your risk tolerance, changes need to be made immediately. If your portfolio risk is lower than your risk tolerance, you still need to make sure it is of sufficient risk for you to meet your goals, considering inflation and taxes.
Step 4. Rebalance your portfolio to a risk level equal to or less than your risk tolerance and sufficient to meet your goals. Make sure you diversify your portfolio within asset class and asset style. Diversification reduces risk. Reducing portfolio expenses and taxes increases returns. Alternatives are designed to reduce risk and increase returns. Trying to time the market increases your risk. Set your asset allocation for the long-term and don’t change it based on feelings of emotion. Stay invested.
Step 5. Most importantly, regularly review and monitor your goals, risk profile and the asset allocation within your portfolio. The results: Improved lifetime probability of financial success and peace of mind.